Don’t bet against the dollar

Some things never seem to change. Every time the U.S. dollar experiences a short bout of weakness, a host of leading economists come out of the woodwork to predict the impending end of the dollar’s long reign as the world’s leading international reserve currency. They do so only to be proven wrong time and again by the dollar’s continued clear advantages over its potential rival currencies. 

Judging by the recent dire predictions of a dollar crash next year by Stephen Roach, Morgan Stanley’s former chief economist, this time will be no different. Following a 10 percent decline in the dollar over the past six months, Roach is boldly predicting that the dollar will crash by as much as 35 percent next year. He is doing so in seeming disregard of a very troubling world economic outlook and the many challenges now facing the Euro, the dollar’s main potential rival. 

The essence of the dollar bears’ current pessimism about the dollar is that the U.S. savings rate is bound to plummet as a result of the stimulus packages associated with the COVID-19 pandemic. In particular, they draw attention to the fact that the non-partisan Congressional Budget Office is now projecting that the U.S. budget deficit will widen to some 16 percent of GDP in 2020 and will remain in excess of 8 percent of GDP in 2021. 

In the dollar bears’ view, such large budget deficits are bound to lead to a marked widening in the U.S. external current account deficit by contributing to a plunge in the overall U.S. savings rate. That in turn will precipitate their long-awaited dollar collapse. 

A key point that the dollar bears overlook is that in today’s world of open capital accounts, currency movements are determined more by the very large amounts of capital crossing international borders each day than they are by the very much smaller amounts of a country’s daily external current account balance. More importantly yet, they do not seem to grasp that in times of a troubled world economy, those flows tend to gravitate towards those countries that are perceived to be safe havens and that have deep and highly developed capital markets, as does the United States. 

In the period immediately ahead, there is every reason to think that the U.S. will again be the recipient of large capital inflows as the result of the likely continued troubled state of the global economy. This would seem to be particularly the case considering that both the International Monetary Fund (IMF) and the World Bank are warning that the world could be on the cusp of a serious wave of emerging market debt defaults. It would also seem to be the case considering that a second wave of the pandemic has started in Europe and that there are ominous signs that the U.S. might not be far behind. 

The dollar bears also seem to ignore the fact that the outlook for the Euro, the dollar’s main potential challenger, looks very troubled. It is not simply that the Eurozone economy has been harder hit by the pandemic than has been the U.S. and as a result the Eurozone is now experiencing price deflation. Nor is it only that European Central Bank President Christine Lagarde is now intimating that the bank is likely to pursue an even more aggressive monetary policy in an attempt to kickstart a moribund Eurozone economy. It is also that Italy and Spain, the Eurozone’s third and fourth largest economies, have serious sovereign debt problems and weak banking systems that could once again pose an existential threat to the Euro.

All of this is not to say that the U.S. has much to write home about as regards its shaky economic fundamentals in the wake of the COVID-19 pandemic. Rather, it is to say that at a time of a very troubled global economic outlook and in a world in which the dollar’s only real rival has serious problems of its own, it is highly improbable that the dollar will be knocked off its perch as the world’s dominant international reserve currency anytime soon.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.