Brad Setser

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The Dollar: It’s an Overhang, not a Hangover

by Mark Dow
July 6, 2009

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Dollar Index 2004 -2009

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

What about the current account deficit? No one home there either. As soon as the deleveraging accelerated, the US current account took a sharp turn northward. In the chart below I use the trade balance, which comes out monthly, as a proxy to capture the rate of change.

US Trade Deficit 1995-2009

Ultimately, the current account story is much more a credit story than an FX story, in my view. And it is fixing itself without much help from the exchange rate. In fact, as you can see above, the increase in the trade deficit coincided pretty well and pretty monotonically with the great credit bubble in the US. So it shouldn’t surprise us that the decline in credit reverses it. (This also has implications for the need for foreign purchases of Treasuries, which has been cited as another concern.)

Fine. If these stories are wrong, does that mean I am bullish the dollar? The answer is no.

The dollar has an overhang problem.

For the past 60 years the dollar has been the only game in town. It was the lubricant for financial and trade globalization, the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for commerce. The world held more dollars, and the world transacted more often in dollars. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the Fed had to provide these dollars; otherwise interest rates at home would have been much higher.

Fast forward to today. The world has undergone a radical transformation. Abstracting from the current global recession, most countries across the world are in much better economic shape than was the case 15 years ago, and their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders — central banks, sovereign wealth funds, international corporations and individuals alike — realize they have accumulated too many dollars over the years. Holding such a high percentage of one’s precautionary balances in dollars no longer makes sense in today’s world. Not because the dollar is bad per se, but because there are so many opportunities to diversify safely.

Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. Sovereign wealth funds have realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. Investment management firms are starting to offer more non-dollar share classes for their products. And Italians, Poles, and Turks — peoples closely linked in one way or another to the euro — are thinking less and less in dollars (it is amazing that they still do at all).

The transactional demand for dollars is also declining. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars. Not any more. Cabs in emerging economies used to prefer payment in dollars. Now it’s not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Bilateral trade, on an ad hoc basis, is ever more frequently eschewing the dollar for other currencies.

With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. With some 70 percent of dollars in circulation held outside of the US, unwinding this overhang may take a long time. This doesn’t mean we can’t have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. But it does suggest that you can expect the dollar to be undervalued relative to any intertemporal, goods market concept of its underlying value for quite some time.


  • Posted by Yoda

    sure, whatever you said. with story like almost everyday. and Fed is not printing as much money? oh great, i must have missed something. and where is the Bond Jedi? any Bond Jedi left?

  • Posted by John

    It took me a while to figure out the math question but I eventually made it, thanks to my Casio, so here’s my Reply…

    Mark, you trash the idea of “stories” that justify some expected outcome in the market and then you give us your own story. Why should we believe that your “overhang” story is any better than the “printing press” story? Or the “less bad” story (which suggests that the dollar may be crap but other currencies are worse)? All of them contain some grain of truth, so please – why is yours any better?

  • Posted by Joe Calhoun

    Expand your time frame a bit. The dollar started falling in 2002; your chart just captures the last down leg after a respite in 2005-6. Same with the trade deficit which started going off the charts in the late 90s. Current account really started to deteriorate about the same time as the dollar.

    Currencies tend to get in a trend and as you point out the trend is hard to change. It’s especially hard to change if policies don’t change. The policies that sent the dollar down the tubes after 2002 haven’t changed and except for the brief interruption of last fall, neither has the trend of the dollar.

    We know in retrospect that too many dollars were printed relative to demand from 2002 to 2007 because the value fell. With rates at zero, it seems unlikely that the carry trade, funded by the dollar, is going away. We know that the current account deficit was not sustainable and unless policy changes it will move back to its previous level. Again, I see no change in policy. In other words, I think both stories are still intact and therefore the dollar’s future course is unlikely to change.

    As for your story, it is also valid but maybe not as much as you think. I live in Miami and while Latin Americans (particularly Brazilians) are more willing to hold their home currencies, they also have an institutional memory of the bad old days. They still don’t trust their governments and it will take several generations to get rid of that distrust.

  • Posted by don

    “Economists are never wrong, only early”
    very true.

  • Posted by Cedric Regula

    I too have worried that all the Dollars sloshing around the world may come home someday, but I was more than a little surprised the way it actually happened last year. The Dollar actually went up! But that of course was the combined forces of EM stock repatriation by US investors, the safe haven effect, and a new one on me….Euro banks do a lot of dollar based lending, and between them and our international banks deleveraging and calling in revolving loans, all of a sudden there was a dollar shortage in the world. Ben responded with all those currency swaps.

    Now you would think this would be a great time to mop up the international Dollars, but the Fed announced $300 Billion in QE instead. The buck fell 5% while I was reading the press release.

    Then the countries in Asia and the Middle east that have trade surpluses and peg to the Dollar end up printing their own currencies, dollar for whatever, so the least worst story has some credibility too. Not to mention all the majors that embarked on QE. Then Sweden just announced a negative interest rate.

    Good point about Brazil and Latin America. Brazil launched the “Real” in 1999 (they do that every 10 years or so) at 1:1 parity with the Dollar (Dollar index was 120 at the time)and now the Real is 50 cents, and the Dollar index has dropped nearly in half too!

    Mexican Peso just went from 10:1 to 15:1.

    So there is lots of room for stories. I think the ultimate one is the world dies in a flurry of paper cuts from all brands of fiat currency.

    But maybe the BRICS and others will move forward with regional trade based basket of currencies. It would bring some sanity to the system, but that would make the ultimate negative take on the buck be lack of global demand. We could pay lots of interest to support the buck, but what for? Cheap oil? We want to cap carbon here anyway. Get a bicycle!

    But we may have to pay lots of interest to get both domestic and foreign investors to buy all our USG debt. So here is where I get confused. Are we going to have an All Mighty Dollar just before the USG turns the lights out? Will the Fed just buy it all and we get the long awaited currency crisis?

    I can’t figure how that part plays out.

  • Posted by Michael


    I got a different take from the article. The big issue that tests the hypothesis that the value of the dollar must fall because of overprinting is that overprinting went into the stratosphere last year but the value of the dollar didn’t fall commensurately nor during or after the bulk of the printing (it mostly fell before and then rebounded). I agree that Mark didn’t make a definitive case (nor could anyone) that the hypothesis is “wrong”, because dollar devaluation could still happen in the future as long as those crisis dollars haven’t been mopped up. But, Weimar Germany, Zimbabwe, Argentina, etc, are very different scenarios in every respect from the 2008 Fed printup, including the level of printing. So, we don’t have any evidence at all to support a claim that the dollar’s value “must” fall, other than non-reserve-currency historical generalizations, and we do have this one recent U.S. episode with no net devaluing YET. The main thrust of Mark’s argument is that there ARE too many dollars out there for the current – and possibly future – economic level of activity to support, but those dollars were created over decades, not in the recent crisis-response printup.

    P.S: Personally, I expect the value of the dollar to fall, precisely because of the “overhang” from the economic, fiscal, and currency imbalances built up during the last few decades and the changes now underway due to the Great Deleveraging and the pathetic attempts to stop it by Government-Borrowing-and-Printing-on-Steroids (no, I don’t think we’ve seen the last of the Fed creating money out of thin air to park in excess reserve accounts, buy Treasuries and MBS, etc, etc).

  • Posted by RodgerRafter

    Another good post, Brad.

    A couple nitpicks from my perspective:

    1. Good economists like you are seldom wrong. Unfortunately far to many have to be wrong in spreading misinformation to suit the needs of their employers (NAR, Wall Street, etc.).

    2. China is still pegging aggressively to the dollar. The RMB has been at low 6.8ish to the $ for a year now. China wants that to continue to promote full employment and economic growth. The US wants that to continue to postpone the inevitable fall of the $ and onset of high inflation. Until the global economy recovers enough for China to feel comfortable, it will continue. As long as the current trends continue, it’ll keep traders from piling into bets against the dollar.

    I think the other big item propping up the dollar for now may have been the Fed’s steady draining of foreign dollar liquidity by letting the swaps expire with foreign central banks. The Fed drained $200 billion in the last 4 months, according to the H.4.1s. They opened up those agreements when the dollar was soaring during the big forced deleveraging of carry trading hedge funds late last year. Does this seem significant to you?

  • Posted by Mark Dow

    I see a few comments. Here are a couple of responses.

    Yes, mine too is a story, but what differentiates it is that there are facts that back it up. Go check the dollar deposits as a share of all deposits in Turkey, Brazil, Russia, and the Philippines, for example, and you will see that they have been declining over time. And then check out the link to the Fed’s balance sheet that I posted and after that take a look at the money multiplier. I bet you’ll see what I mean.

    Also, I am not trashing stories; I am just pointing out that saying you should never fight the market is not the same as saying the market is always right. In fact, the market is often wrong–until it finally gets it right. If you can figure out the story–true or not–you can do well in the market. If you can’t, you won’t.

    I see a lot of guys still insisting that the Fed is still printing money. Some elements are expanding and others are contracting, but base money has not been expanding since December of last year. Moreover, and much more importantly, the money multiplier is still contracting. In short, the global supply of dollars is just not expanding the way most people continue to assert when you look at the broader monetary aggregates, which is what matters.

    Lastly, I don’t think it is fair to say the dollar has been going down, ipso facto too much money must have been printed. Maybe, maybe not. The analytical problem I have with this is that it makes no allowance for stock adjustments, ie. an overhang, which is exactly the point I was trying to get across.

  • Posted by Cedric Regula


    The Fed is doing QE. They bought $8 trillion of mid term treasuries today. In march they said they will do $300 billion by end of year. Along with $1.2 Trillion in MBS and $200 Billion in GSE corporate bonds. And they are printing money to do it.

    Why this doesn’t appear in base money is a good question.

    Where can you find data on the money multiplier? I know the Fed publishes the velocity of money, since it is easily calculated from bank data. But I thought the money multiplier is a little harder to get a handle on. In fact so hard that the Fed always blows it when it comes to tightening time.

    The velocity of money runs in a tight range year over year normally, but is at half its norm.

    The money multiplier in a 8% fractional reserve system can go as high as 12 mathematically, but it never really gets that high. But it can have big and rapid swings.

    But the reason too many dollars is not or does not appear to be a problem at this time is because consumers and business are trying to deleverage and demand is way down. So banks can keep it in their vaults. At least that is the US economy story I believe.

    Then it would make some sense that high oil prices would create international dollar demand for settlement. Here’s a irony to gnaw on. The dollar and oil have been going different directions since March…and all the talk on CNBC is “it’s the long oil/short dollar trade”… it’s the speculators and dollar liquidity moving the commodity markets…not trade.

    So that implies there are too many dollars on Wall Street…and in my opinion the Fed put them there!

  • Posted by Cedric Regula

    “The Fed is doing QE. They bought $8 trillion of mid term treasuries today..”

    S/B Billion.

  • Posted by mjm


    So if foreigners realize they dont need to hold dollars and start diversifying then what happens to their dollar reserves? Will they be spending these dollars on US goods rather than loaning them to the US consumers to spend them(especially if the dollar falls in value)

  • Posted by Indian Investor

    There’s a widespread misconception that demand for dollars comes from economic factors. If the US imports 1000 widgets from China, and in turn exports only a 100 widgets to China, absent capital flows, RMB/USD = 0.10!Dollars are fundamentally worthless once they leave the US territory, because, like all currencies, the greenback is legal tender, and can be enforced for settlement of debts only within US territory.
    The “demand” for dollars never resulted from foreign cab drivers being fascinated with Mr. Washington’s photographs. The US military had to fight wars and kill millions of innocent people worldwide for several decades on various pretexts to make Americans eligible for the previlege of making and sustaining the dollar as the world’s primary reserve currency.
    As long as people don’t really grasp the full significance of Dick Cheney’s reported comment that the US dollar gets more than 90% of its value from the US military, this kind of carnage will go on.
    The international monetary system doesn’t only destroy innocent lives in foreign countries.It also makes millions of Americans jobless, and steadily over decades erodes America’s productive capabilities and real wealth.

  • Posted by Simon

    I with you on this one Indian Investor.

  • Posted by FollowTheMoney


    do you have link to when Cheney said “90% of its value from the US military”.


  • Posted by Tony

    thanks. gave me something to think about.

  • Posted by Rien Huizer


    I do not know what an index that consists mainly of EUR,(if you include the SKR (pegged to the Euro) and the SFR (cannot move too far away, like the GBP.), CAD (also limited range of motion) and JPY – in theory the most flexible, but not in practice) has to do with USD overhang in emerging markets.

    I guess that the truly remarkable story is the fact that the index (based on 1973 weights) is still so close to 100!

    Neither Europe nor Japan want to USD to lose its reserve status, as long as the US acts responsibly.

  • Posted by a kempis

    Economists are never wrong only early…….
    Very Funny! How’s about this:

    “Economists are right twice a day!!!!!!!!”

  • Posted by Brick

    Its hard to quibble with much that you have said Mark, but if I had to it would be that recent history may not be a good pointer to future behaviour. You contend quite rightly that the US deficit has played no part in the movements of the dollar, but there are scenarios where it could. In the situation where the rest of the global economy does begin to recover and the US does not then the deficit becomes important, or if there were a serious disruption in the Chinese economy. Any potential drop in demand for treasuries would lead to either increases in interest rates or more significant QE either of which could lead to a deteriorating view of the US economy thus speeding up diversification away from the dollar as a reserve currency. I don’t think the time is nigh just yet but agree that the future for the dollar looks shaky.

  • Posted by Ben, the drama Queen

    Index up, index down. Index left and even right. It’s a fool’s game. Always was. In fact it was devised by and for the blindfolded to play with, as if they saw… We can even change the index comp/weights yes, but – to what purpose?

    To make “competitive devaluations” go away? “Competitive”? Competitive to what?

    So you see, none at all.

    As long as I keep My interest rates hostage, ’tell you what – I care not.

    You can play with the index all you want… graph it straight or upside down. And say it all too…

    We’ll just keep this amongst us, the Monkeys.

  • Posted by Mark Dow

    Cedric – the effects from Treasury and mortgage purchases do show up in base money. You will have to look at the asset side of the Fed’s balance sheet to see it. But these purchases are being offset by a decline in the private sector’s use of the Fed’s financing facilities, so the overall balance sheet is not growing.

    The page you need to see is called “Factors Affecting Reserve Balances”. Here’s the link:

  • Posted by Laobaixing
  • Posted by Phillip Huggan

    Hello federal debt? Maybe I overvalue its importance, but the fact Democrats are almost as free spending (afraid to raise taxes) and pro-rich people as GOP is the deathblow to USD. And Obama butressing banks, harmed in declining USD environment, rather than say, manufacturing wind-turbines (banks given trillions and autos given tens of billions is no comparison) for export…

  • Posted by Phillip Huggan

    …by the time the is the will to raise taxes you probably won’t have free interest rates, so will be net revenue neutral with more debt and healthcare costs.

    In Canada, we went from basketcase in 1993 to model by having a non-Chicago School finance minister as Rasputin (decided not to deregulate our banks in 1998) and then as PM. Now with a Neocon economist as PM we are back to flat taxes and debt…
    You guys are right where we were in 1993, and I guess a temporary flight to quality is blinding you of the path to solvency. Banks fare horribly in a depreciating environment and that’s who you given all your money to.

  • Posted by 罗臻

    Relative to what? Europe and Japan’s demographic and budget problems are worse than the U.S. Who does that leave? China is pegged to the dollar and inflating like mad, and politically speaking, will Western Europe, Russia, or Japan abandon the dollar for the yuan?

    Now, if you’re comparing the dollar to hard assets…

  • Posted by Ricardo

    Considering usual transmission mechanisms to prices, shouldn’t we look at broader money supply? In that case, we would note that there was not a large increase (considering trend growth) to unleash all those worries.
    The big problem would be focused on how Fed will react going forward, once credit restart flowing in the economy. My impression is that we are too early in the process to be too worried about this. That’s my view not only because of output gap, which is just too wide to justify price concerns, but also because of likely new regulatory framework (I just heard considerations to change capital requirements from 8 to 15%!), so I don’t really see broad money expanding anytime soon.
    Regarding the financial stabilization in the EM world allowing people to start perceiving value in its currencies, I think you are totally right. I am positive on EM currencies and BRL in particular, but I am just a bit skeptical about our institutions. I think there is room for appreciation but the road is just too long to make me believe that we are at a verge of a considerable change in paradigm.

  • Posted by Michael


    Which U.S. goods would they buy, and why haven’t they already been buying them (in sufficient quantities to use up their dollar reserves)?

    Question: What product exactly does the U.S. produce at a comparative advantage, does not keep the price excessively high through subsidies, and does not restrict for “nation security” reasons?

    Answer: Low-return, high-risk semi-fraudulent securitized finance. I think the productive nations of the world have had about as much of that product as they will ever want.

    At least, that’s my story.

  • Posted by don

    罗臻 makes an excellent point. Why should reserve holders shift the makeup of their reserves? I’m not sure the existing stock of dollar reserves abroad is all that important, except to the extent that foreign holders doubt the value of the currency and the inherent instability if they all try to escape from the dollar at once. However, even in such an instance, absent a change in the purchasing power expectations, the event would merely present a short run opportunity to buy an asset cheaply.
    Ultimately, the value of the dollar depends on its purchasing power, which depends on whether one believes the government will at some point monetize its debt. In that regard, comparisons to the U.S. debt to GDP ratio after WWII are misleading. It’s like comparing a owed by a healthy 30-year-old with no non-housing assets of 4 times annual income to one held by an unhealthy 60-year-old with no non-housing assets of 4 times annual income. The reason the debt was incurred matters, also. Someone who has has no excuse for his debt beyond living consistently beyond his means seems a poorer credit risk than someone who consistently lived within his means but had the same debt load as a result of a one-time catastrophe from which he has fully recovered.
    In short, for the long-run prospects of the dollar, look to the fiscal discipline of the government as entitlements are hit by the tsunami of baby-boomers.

  • Posted by Too Much Fed

    Cedric Regula said: “Where can you find data on the money multiplier?”

    Is this it?

  • Posted by lewy14


    It’s true that base money is not increasing – but I’d claim that the assets on the Fed balance sheet have become crappier longer duration and lower credit quality than they were six months ago. MBS and longer duration Treasuries have replaced the swaps, CP, etc which are running off.

    This matters with respect to “exit strategy”.

    By engaging in QE and CE at all, the Fed has put the prospect of monetizing the Federal deficits (and questionable mortgage debt) squarely on the table.

    The only claim the Fed can make against accusations of monetization is the credibility to reverse QE/CE.

    When real economic green shoots sprout, it will be politically very, very difficult to sell the Fed’s assets on the market to mop up liquidity. The solvency of the Fed itself could be an issue here as well.

    Domestic fiscal discipline is honored exclusively in the breach and there is no evidence of this trend changing.

    This is the political reality the Fed operates in.

    Dollar stability is predicated on credibility, which is slowly eroded by the inexorable progression of the arithmetic of debt.

  • Posted by a

    “Economists are never wrong, only early”

    Surely better would be, “Economists are never wrong, only early or late.” This is false, but at least it’s less false.

  • Posted by FX Internals

    I think the better statement is that “economists examine history and traders bet on the future.”

    But relatively absent from the comments is the fact that the value of the USD is always measured in relation to another currency. So it matters just as much what is happening in that other country as what is happening in the USA.

    Also, the value of the USD is directly tied to the inflation vs. deflation fight that is going on in the world economy. The massive credit bubble / deleveraging that is going on is being fought by the FED with inflationary weapons. Who will win? Will the FED succeed in inflating our way out of this and thus devaluing the dollar? Or will the forces of deflation win, which will actually increase the value of the dollar?

    My bet long term is that deflation will win, deleveraging will occur, and overall debt loads in the world will decrease. Less debt == less money == higher value of money that still exists.

    Japan is a pretty good example of this. The USDJPY was around 300 in 1975, fell to 175 by 1978, inflated its way to 277 by 1985 and then fell off a cliff all the way down to 84 by mid 1995. Just as the Nikkei was falling, so was the YEN. The deleveraging of their debt was a massive force during this time, and their gov’t was desperate to stop it borrowing more than 1x GDP to fight that fight. And still they lost, Yen deflation won, and the Yen got massively stronger vs. the USD from 1975 through 1995.

  • Posted by baychev

    to talk about base money in times when everything but chewing gum is purchased on credit is so out of touch with reality.