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Deflation and the Dollar

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Several Minyans have questions concerning the impact of deflation (I am not saying there is deflation, I am just responding to the question) on the dollar. There have apparently been some newsletters discussing deflation and its positive impact on the dollar: one newsletter referred to the huge amount of debt (denominated in dollars) as a "synthetic short position in the dollar".

My position is that deflation will not necessarily cause a rally in the dollar: there are many cross-currents (much of which concerns how central banks, which have been given the ability to control money supply, react to the situation) that will determine how the dollar will react in a deflationary scenario. I'll discuss just a few below.

First of all, deflation (as the opposite of inflation) works like this: purchasers of goods who perceive prices will go down in the future will wait to buy things. This can happen when there is over capacity in production. This causes the propensity to hold dollars (not spend) to increase. Corporations' profitability suffers as consumers pull back spending. As the demand for dollars increases, holders want to deposit those dollars and earn interest.

The Federal Reserve in order to combat this situation of higher demand for dollars (and lower demand for goods) begins to lower rates, effectively increasing the supply of dollars. Holders of dollars, realizing they are not getting much from depositing their dollars on account, are discouraged from depositing the dollars and encouraged to spend them (or put them in other assets like stocks). The lower interest rates also act to lower costs for corporations, helping profitability.

The end product of this process is increased debt: this is how the supply of money enters the system.

We have been through this cycle in various magnitudes since the Federal Reserve was instituted. There is no dispute that this process is responsible for the creation of debt. The level of debt in the U.S. relative to GDP is at historically high levels. There is dispute as to whether or not this matters. I believe it is how we handle the liquidation of this debt that has implications for the dollar under a deflationary scenario.

If deflation begins to spiral downward it is bad for debt holders: they must pay back their debt in dollars that will be worth more in the future. They will logically attempt then to pay back this debt as soon as possible. They will be motivated to sell assets to pay down debt. Many of these assets will of course be denominated in foreign currencies: think of a corporation in debt that owns assets around the world. As corporations sell these non-dollar assets they sell the foreign currency and buy dollars to pay off the debt. This process of unwinding debt in a deflationary scenario strengthens the dollar and this is what the writer means by "huge debt acting like a synthetic short position in the dollar".

The Federal Reserve wants to avoid this situation at all costs and is on record as saying so. After all, the U.S. government is the world's largest debtor and would suffer greatly under deflation: their goal is to re-inflate so as to pay back their debt with cheaper dollars in the future.

The writer's scenario occurs, at least initially, when the Federal Reserve loses control of the spiral and has trouble stopping it. The problem with the end result of a lower dollar is that it assumes two things: that the Federal Reserve will not print dollars to infinity and that there will be only minor defaults by debt holders. Either one will cause less confidence in the dollar and the dollar to weaken.

The more defaults there are and the more the Federal Reserve tries to fight the forces of deflation by printing dollars, the more pressure on the dollar. Enough of it and it will cause the dollar to drop in the face of deflation, causing U.S. interest rates to actually rise. This is called stagflation.

These are only a few of the cross-currents that can make a direct cause and effect statement misleading.


No positions in stocks mentioned.

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