The third quarter results session is upon us, and the the Wall Street newspaper reports that sixteen companies have already indicated that a “strong” dollar will hit their bottom line. The technology sector of the S&P 500, which generates more than half of its turnover abroad, is highly exposed to currency risk. Companies that produce materials, as well as energy companies and consumer staples, are also in the sights of a strong dollar.
Profit concerns generated by fluctuations in the US dollar have not always been the case. In 1944, the Bretton Woods Agreements established a new global monetary system. Its hallmark was stable exchange rates. This stability was accompanied by a general acceleration of growth in the postwar golden age. In 1973, the system was swept in the trash by President Nixon’s broom. With that, the world has entered an era of flexible, unstable exchange rates, or what my good friend, the great Jacques de LarosiÃ¨re, calls an anti-system.
This instability in exchange rates creates problems – big problems – for the economy as well as for businesses. If we look at the onset of the Great Recession, we should ask ourselves whether exchange rates were stable in the fall of 2008? Ultimately, one of the few who laser-focused on what he considers the world’s most important prize, the dollar-to-euro exchange rate, was another good friend, Nobel Laureate Robert “Bob Mundell. The founding father of the supply-side economy, Bob continues to focus on prices. This certainly separates Mundell from Ben Bernanke, who was chairman of the Federal Reserve in September 2008. Bernanke saw fit to ignore fluctuations in the value of the dollar. Indeed, changes in the value of the dollar’s exchange rate did not appear as one of the six measures of the âBernanke dashboard,â the one the president used to assess the relevance of monetary policy.
Well, let’s take a look at what Mundell saw in the months surrounding the Lehman collapse and the onset of the Great Recession. He observed a wild swing in the dollar-euro exchange rate (see table below). Over the July-November 2008 period, the greenback appreciated by nearly 24% against the euro. This oscillation was accompanied by an even more marked oscillation in the price of oil. It plunged 57%. Gold also saw a sharp drop of nearly 22%. And, in line with Mundell’s theories of supply, changes in exchange rates transmit inflation (or deflation) to economies, and they can do it quickly. It is therefore not surprising that the annual inflation rate in the United States went from an alarming rate of 5.6% in July 2008 to outright deflation of 2.1% a year later. This swing of 7.7 percentage points is truly astonishing.
So in terms of monetary policy, Mundell saw the obvious: the Fed was too strict, overwhelmingly too strict. The dollar was soaring and commodity prices were collapsing. Fed Chairman Bernanke didn’t see any of this because exchange rates weren’t even on his dashboard. Sadly, the Fed’s massive monetary squeeze and the resulting volatile dollar sent the economy into a recession.
Alright, here we are again. Today there is a lot of tension in the international anti-system. The strength of the dollar has exacerbated the pain in emerging markets. Indeed, emerging markets and commodities are under strong downward pressure. And, several emerging market currencies, notably the Argentine peso, collapsed, causing inflation to spike. It’s time to get rid of the international anti-system and move towards stability
This earnings season isn’t the only time companies have expressed concern about exchange rate volatility and the associated risks. In 2017, I gave two of my assistants, Zackary Baker and Cameron Little, what was expensive work. They read each annual report of America’s Top 100 Companies to determine whether the companies have rated exposure to currency risk, whether they have hedged those risks, and whether they have quantified their currency losses.
As shown in the chart below, 100% of the largest US companies indicated they were exposed to currency risk, and 80% indicated that they had quantified their losses. It is obvious: American companies should form a strong coalition to support a new system which would ensure more fixity and predictability of exchange rates.
So what needs to be stabilized? The two most important currencies in the world – the dollar and the euro – should, via a formal agreement, trade in a zone of stability ($ 1.20 – $ 1.40 per euro, for example). Under such an agreement, the European Central Bank (ECB) would be forced to maintain this zone of stability by defending a weak dollar through dollar purchases. Likewise, the US Treasury (UST) would be forced to defend a weak euro by buying euros. What exactly would have happened in such a (counterfactual) system since the introduction of the euro in 1999 is illustrated in the graph below. When the euro-dollar exchange rate was less than $ 1.20 per euro and the euro was weak, the UST would have bought euros (in the periods 1999 – 2003 and 2014 – 2019). When the euro-dollar exchange rate was above $ 1.40 per euro and the dollar was weak, the ECB would have bought dollars (over part of the period 2007-2011).
Stability may not be everything, but everything is nothing without stability.