The US dollar will continue to benefit from the financial market crisis

Foreign Exchange Outlook : Foreign Exchange market analysts say the market will be “distracted” tomorrow by the US election but it won’t have a big effect on prices. We are not so sure. For one thing, the market likes big, decisive actions. A landslide by Obama, which is a real possibility, will be rewarded. But the longer-lasting effects of the election are yet to come. They pertain to political philosophy as much as economic outcomes, and here’s how:

We review a ton of headlines and skim hundreds of stories looking for the gold nuggets that form the basis of an foreign exchange outlook. Sometimes it’s all just noise, especially lately when it’s hard to know what is critical and what is not. The government “saving” Bear Stearns but allowing Lehman to fail was obviously a big deal but we didn’t see at the time that it would have such an enormous ripple effect. Now everyone blames the Lehman failure for consequences still coming out (like the HBOS write-down today and tomorrow’s data on credit default swaps). Today we have a tidbit from Economy.com that hadn’t sunk in yet but we now see as the single most important thing for the next 9-18 months. Here it is again: “Nationwide, 7.3 million American homeowners are expected to default on their US mortgages between 2008 and 2010, about triple the usual rate, according to Moody's Economy.com, a research firm. Some 4.3 million of those are expected to lose their homes.”

With 111.16 million households in the US as of 2007, the default rate is 6.6% of all households. The number of new homeless households is 3.8% of total households. Quite apart from the effect on unemployment, retail sales, home prices and other standard economic variables, think about the effect of this many new homeless households on national health, crime rates, and the socio-political Zeitgeist.

The Far Right dislikesthe idea of a social contract-the US is a country of individualists. You can’t have individualism as your core ruling principle and then provide a nanny state, aka socialism. Bush One tried to soften this with “compassionate conservatism,” and we saw how well that worked out with Bush Two in New Orleans. Nobody doubts that if Katrina had happened in (white, Republican) Orange County, the place would be rebuilt better than ever by now. The bottom line for the US is the question of what should the people expect of government in times of crisis as well as regular times? Some things can be provided only by government, like national defense, transcontinental highways, and so on. Should the state also “take care of” these 4.3 million people who will become homeless? We say the US is about to give itself a lesson in Political Science 101. We fondly imagined this debate would end with the election tomorrow, but surely we cannot brush under the rug such a high number of homeless households as 4.3 million.

We probably need to assume that a McCain presidency would mean a policy of letting the private market solve the homeless problem. Foreign Exchange Markets basically don’t like poor people, so this simply would not work.

Assuming we get Obama and assuming he believes in a social contract that deals with 4.3 million homeless households, the turmoil is going to be horrendous. Conservatives want to prevent the “Europeanization” of America. Economists worry, too - can it be done without the price distortion and misallocation of resources that are so prevalent in Europe? In France, for example, the state requires a failing company to remain in operation to provide employment.

This is bad business and stupid public policy. Surely the US wouldn’t go that far-?

Something very big is happening.

It’s not clear what effect it will have on the US dollar exchange rate, but longer run, a Europeanized America will have even bigger deficits and without the safety net of the Maastricht Treaty and Stability Pact, not to mention the single central bank mandate of controlling inflation. We complain that “Europe” lacks region-wide institutions, hence the scattershot national bank rescue plans, but the eurozone does have that one, giant, splendid thing named “fiscal prudence.” With the world falling down around our ears, nobody much cares about fiscal prudence today, but that won’t last forever. And it can get worse. Maybe the number of homeless households is not 4.3 million but double that. Maybe the government rescue plans only delay getting the true housing market bottom and the end of bank consolidation, both prerequisites for recovery. Maybe sovereign wealth funds and others lose confidence in the US and stop buying all the trillions in new paper the US Treasury will issue to pay for it.

Longer run, you can see that we can easily make the case for the dollar exchange rate falling out of favor. In the meanwhile, falling commodity prices, impending recession worse in other places than in the more robust US, and additional shoes left to drop also outside the US all imply the US dollar will continue to benefit from the financial market crisis. In particular, we expect the emerging markets - inlcuding China - to get harder hit than anyone is now expecting.

If and when one of them hits the wall, the dollar will be the immediate beneficiary.

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Barbara Rockefeller
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