Growing debt will push the dollar lower

 
Philip Salter
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IN A trick worthy of the great escapologist Harry Houdini, Treasury Secretary Tim Geithner has avoided hitting the US debt limit of $14,300bn by under-investing in social security and delaying debt auctions. However, creative accounting can only get a country so far. At some point the authorities need to deal with their fiscal profligacy and loose monetary policy.

With Paul Ryan, the Republican chairman of the budget committee, at loggerheads with President Obama’s spendthrift administration, there is a risk that come 2 August the US will default. However, markets are expecting Republicans and Democrats to come to an agreement before this and holders of dollars will be hoping they are right. Angus Campbell of London Capital Group says “the overriding issue for the US is to address their colossal debt burden. They desperately need to get their house in order just as the Eurozone is trying to do and this will involve a great deal of pain.” He believes that this is the only way that sentiment towards the US dollar will improve. The closer we get to 2 August without a resolution, the less attractive the dollar becomes.

Although Geithner’s delaying tactics might strengthen the dollar in the short-term, Jordan Lambert of Spreadex believes that in the medium to long-term “as the US is due to pay back even more interest to investors due to the higher level of borrowing, this could make it even more difficult to reduce its deficit and prompt another warning or an actual downgrade from the credit rating agencies.” He also suggests that over the long-term oil might drive the dollar down, as emerging market demand pushes oil’s price up, in the process stoking inflation.

When the long run comes around, as it always does, the dollar could have even lost its dominance as the global reserve currency. A McKinsey survey from last year found that fewer than 20 per cent of executives expect the dollar to be the dominant global reserve currency by 2025. As Lambert says, “China will ultimately play an important role here. Currently China is taking funds away from dollar assets and diversifying their foreign reserves by buying euro, yen and Russian rubles to name a few, which may reduce the power of the dollar.” However, if the dollar does lose its shine, there doesn’t appear to be an obvious replacement. Campbell says: “Japan’s yen and the European Union’s euro both have ageing populations and China’s yuan is not developed enough, so for now the US dollar will remain the world reserve currency.”

Dr Eamonn Butler of the Adam Smith Institute calls Geithner’s slight of hand “a fudge”. Although he thinks “a great deal of fudging seems possible before the inevitable disaster happens,” the trouble is “the more fudge you have covered yourself in, the harder the clean-up afterwards.” The US is famed for being able to renew itself. Time will tell whether on this occasion they will be able to find the key.