Friday, September 11, 2009

Formal devaluation is unlikely

I am coming back to this idea of devaluation today. I think that a formal devaluation is unlikely because there is nobody capable of undertaking such a devaluation who has an incentive to announce it formally. I think that the two groups that have the power to devalue the US currency are:
1) The Federal Reserve
2) Foreign countries who maintain a peg with the US dollar

There is a third group that I would group together and generally call "private investors"; this group is also powerful enough to devalue the currency. But this group is not cohesive to the point that they would make an announcement, or an overnight adjustment. Investors can affect the value of the dollar if a critical mass of them completely lose trust in the dollar and shift their preferences to exclude any sort of dollar based asset. This has happened on a microscopic scale, and could be a growing force in the coming months. But the two groups who are powerful enough to create an overnight adjustment both have incentives not to do so. Let's start by looking at the Fed.

The Federal Reserve will not announce a devaluation, even if their policy indicates that a significantly weaker currency would help the economic situation of the world. The reasons for this are complicated, but I think a short summary would be that they would find an abrupt devaluation to be too blunt and unrefined of a tool. There would also be (legitimate) worries about what such an action would do to future expectations; once a monetary authority loses the faith of its citizens it requires years, if not decades to regain that faith. I think that the Federal Reserve rightfully considers inflation expectations to be one of the most important determinants of monetary policy. Finally, the Federal Reserve, like all dominant institutions, suffers from hubris, and they will continue to think they can find a more elegant solution to continued problems. Thus far, I should note, they have been correct in that assumption. The Federal Reserve may come under political pressure should economic conditions worsen from where they are (or not get better for a long time.) But I think that it is safe to assume that the Fed will be resistant to extreme ideas such as announcing a double digit inflation target or anything else that could constitute a devaluation.

The second group, countries who peg their currency to the dollar above the market rate, could devalue the dollar simply by getting rid of the peg. Countries such as Saudi Arabia, UAE, Kuwait, and China fall into this category. These countries may abandon their peg, but I think that the most powerful devaluing effects would come from shifts in asset preferences rather than peg abandonment. If the large dollar hoders of the world switched out of dollar assets into real assets (plants, equipment, natural resources, equity in existing firms, precious metals, energy storage, commodity storage, etc.) there would be a powerful effect depreciating effect on the dollar. I believe this is the source for future devaluation of the dollar, but countries who take this strategy have every incentive to cloak their intentions and prop up the value of the dollar while they are making these purchases. As I have talked about in other posts, it appears more and more likely that China is taking exactly this tack. As the strategy becomes more clear, it could escalate in such a way that the dollar (and all other currencies to a lesser extent) could come under an incredible amount of downward pressure. This is the type of devaluation that I am watching for, but it will not be formal. It will start slowly and build in speed. It is pretty clear to me that, barring another deflationary/de-leveraging wave, we are already well underway in the process I have just described.

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