Greece Debt Concern Whipsaws U.S. Dollar

This article was originally published by the Fiscal Times on Friday, Feb. 19, 2010.

When European economies suffer turmoil, the dollar is considered the only safe haven

By Katherine Reynolds Lewis

As European policymakers scramble to resolve fiscal problems in Greece, the fast-changing news about the country's sovereign debt crisis has raised havoc on the value of the euro — and the dollar.

When the situation looked particularly grim, currency traders dumped euros and scooped up U.S. dollars. When things seemed to improve a little, traders bought euros and the U.S. currency weakened again, as was the case this week. Get used to this back and forth, experts say.

"Over the course of the year we're going to see phenomenal volatility," predicted TJ Marta, chief market strategist at Marta on the Markets, a research firm based in Scotch Plains, N.J.

But the ebbs and flows of markets can't obscure the underlying truth that while the United States is on a projected course of massive budget deficits for years to come, the dollar remains the reserve currency for the world. As much as Chinese and other investors may disapprove of U.S. fiscal policies, they don't have a lot of alternatives — either to dollars when it comes to a reserve currency or U.S. Treasury bonds when it comes to a safe investment.
"If I looked at the United States in isolation, I'd have to conclude that the United States is on the cusp of a major currency crisis," said Desmond Lachman, a resident fellow at the American Enterprise Institute, a nonpartisan research center. "When you compare the United States to its main competitors, the Japanese or the Europeans, you're left with the conclusion that maybe the United States is not so bad."

The euro has lost ground recently over deepening worries about swelling budget deficits in Greece and other weak economies in the region. Eurozone governments warned Greece this week that it will need to take extra measures if current spending cutbacks don't bring its massive deficit down.

Greece’s bankruptcy stems from a legacy of inefficient government, excessive spending, archaic regulations, and unsustainable entitlement and retirement spending. Previous efforts at pension reform touched off rioting in the streets. The country’s fiscal problems have roiled the currency and debt markets in recent months, after Greece’s 2009 budget deficit reached record levels and the nation’s overall debt topped 113 percent of the country’s gross domestic product.

Investors worry that Greece will default on its debt or need to be bailed out by other European Union countries, and that it will be politically impossible to reform the country's pension or financial systems to restore fiscal balance. While Greece's problems are the most severe and immediate in the EU, other countries in the region face similar challenges: low birth rates that mean there are fewer young people to replace retiring workers; a rapidly expanding elderly population that is counting on an extensive social safety net; and powerful unions that resist any cuts to national health care and pension programs.

Spain isn't far behind Greece when it comes to a possible default on government debt, Lachman said. Countries such as Ireland, Portugal and Italy all have terrible problems when it comes to public finance.

"This will play out over a number of years, but the markets will worry about whether the euro is really going to hold together," he said. "The only currency that gives them safe haven is the dollar."

At the height of the financial crisis in the fall of 2008, investors fled to U.S. Treasury notes and other dollar-denominated assets as a safe haven in an uncertain world, which pushed up the relative value of the dollar. But as financial markets stabilized and the global economy seemed to be on a path to recovery, investors sold some of those safe investments, pushing the dollar down again, to about 7 percent off its high in March 2009, when measured against a basket of other currencies.

In the near term, a weaker dollar is actually good news for the U.S. economy, because it makes exports more competitive abroad. "It's a plus for the expanding economy and we do expect trade to lead the recovery for the next year or year and a half," said Gus Faucher, director of macroeconomics at Moody's Economy.com in West Chester, Pa.

Ultimately, however, the federal government must take concrete steps to restore long-term fiscal balance in order to avoid alienating overseas investors, experts say."What we're worried about in the future is if we don't get our fiscal house in order, we could see problems in the exchange rate," said Anne Vorce, policy director of the fiscal policy program at the New America Foundation, a nonpartisan public policy group. "We could have a dollar crisis."

The longer policymakers wait, the more the solution will cost, Vorce noted. "If our investors are worried that looking ahead we're going to inflate our way out of the debt or even default on it, they're going to demand higher interest payments or shift their assets out of anything dollar denominated," she said.

At some point in the next decade, investors will demand that the U.S. government balance the revenue coming in with long-term obligations to Medicare, Social Security and interest on the national debt, Marta said. "We'll hit a tipping point at some time between now and 2019 when the world just says, you're done," he predicted.

As European policymakers scramble to resolve fiscal problems in Greece, the fast-changing news about the country's sovereign debt crisis has raised havoc on the value of the euro — and the dollar.

When the situation looked particularly grim, currency traders dumped euros and scooped up U.S. dollars. When things seemed to improve a little, traders bought euros and the U.S. currency weakened again, as was the case this week. Get used to this back and forth, experts say.

"Over the course of the year we're going to see phenomenal volatility," predicted TJ Marta, chief market strategist at Marta on the Markets, a research firm based in Scotch Plains, N.J.

But the ebbs and flows of markets can't obscure the underlying truth that while the United States is on a projected course of massive budget deficits for years to come, the dollar remains the reserve currency for the world. As much as Chinese and other investors may disapprove of U.S. fiscal policies, they don't have a lot of alternatives — either to dollars when it comes to a reserve currency or U.S. Treasury bonds when it comes to a safe investment.

"If I looked at the United States in isolation, I'd have to conclude that the United States is on the cusp of a major currency crisis," said Desmond Lachman, a resident fellow at the American Enterprise Institute, a nonpartisan research center. "When you compare the United States to its main competitors, the Japanese or the Europeans, you're left with the conclusion that maybe the United States is not so bad."

The euro has lost ground recently over deepening worries about swelling budget deficits in Greece and other weak economies in the region. Eurozone governments warned Greece this week that it will need to take extra measures if current spending cutbacks don't bring its massive deficit down.

Greece’s bankruptcy stems from a legacy of inefficient government, excessive spending, archaic regulations, and unsustainable entitlement and retirement spending. Previous efforts at pension reform touched off rioting in the streets. The country’s fiscal problems have roiled the currency and debt markets in recent months, after Greece’s 2009 budget deficit reached record levels and the nation’s overall debt topped 113 percent of the country’s gross domestic product.

Investors worry that Greece will default on its debt or need to be bailed out by other European Union countries, and that it will be politically impossible to reform the country's pension or financial systems to restore fiscal balance. While Greece's problems are the most severe and immediate in the EU, other countries in the region face similar challenges: low birth rates that mean there are fewer young people to replace retiring workers; a rapidly expanding elderly population that is counting on an extensive social safety net; and powerful unions that resist any cuts to national health care and pension programs.

Spain isn't far behind Greece when it comes to a possible default on government debt, Lachman said. Countries such as Ireland, Portugal and Italy all have terrible problems when it comes to public finance.

"This will play out over a number of years, but the markets will worry about whether the euro is really going to hold together," he said. "The only currency that gives them safe haven is the dollar."

At the height of the financial crisis in the fall of 2008, investors fled to U.S. Treasury notes and other dollar-denominated assets as a safe haven in an uncertain world, which pushed up the relative value of the dollar. But as financial markets stabilized and the global economy seemed to be on a path to recovery, investors sold some of those safe investments, pushing the dollar down again, to about 7 percent off its high in March 2009, when measured against a basket of other currencies.

In the near term, a weaker dollar is actually good news for the U.S. economy, because it makes exports more competitive abroad. "It's a plus for the expanding economy and we do expect trade to lead the recovery for the next year or year and a half," said Gus Faucher, director of macroeconomics at Moody's Economy.com in West Chester, Pa.

Ultimately, however, the federal government must take concrete steps to restore long-term fiscal balance in order to avoid alienating overseas investors, experts say."What we're worried about in the future is if we don't get our fiscal house in order, we could see problems in the exchange rate," said Anne Vorce, policy director of the fiscal policy program at the New America Foundation, a nonpartisan public policy group. "We could have a dollar crisis."

The longer policymakers wait, the more the solution will cost, Vorce noted. "If our investors are worried that looking ahead we're going to inflate our way out of the debt or even default on it, they're going to demand higher interest payments or shift their assets out of anything dollar denominated," she said.

At some point in the next decade, investors will demand that the U.S. government balance the revenue coming in with long-term obligations to Medicare, Social Security and interest on the national debt, Marta said. "We'll hit a tipping point at some time between now and 2019 when the world just says, you're done," he predicted.