The third‐quarter earnings session is upon us, and the Wall Street Journal reports that sixteen companies have already indicated that a “strong” dollar will hit their bottom lines. The S&P 500’s technology sector, which generates more than half of its revenue overseas, is heavily exposed to currency risk. Firms that produce materials, as well as energy companies and consumer staples, are also in the crosshairs of a strong dollar.
Profit worries generated by the zigs and zags of the U.S. dollar were not always the case. In 1944, the Bretton Woods Agreement established a new global monetary system. Its hallmark was exchange‐rate stability. That stability was accompanied by a general acceleration of growth in the post‐war golden age. By 1973, the system had been swept into the dustbin by the broom of President Nixon. With that, the world entered an era of flexible, unstable exchange rates, or what my good friend, the great Jacques de Larosière, terms an anti‐system.
This exchange‐rate instability creates problems — big problems—for the economy as well as corporations. If we look back at the onset of the Great Recession, we should ask, were exchange rates stable back in the fall of 2008? As it turns out, one of the few who had a laser focus on what he deems the most important price in the world, the dollar‐euro exchange rate, was another good friend, Nobelist Robert “Bob” Mundell. A founding father of supply‐side economics, Bob is always focused on prices. That certainly separates Mundell from Ben Bernanke, who was Chairman of the Federal Reserve back in September of 2008. Bernanke saw fit to ignore fluctuations in the value of the dollar. Indeed, changes in the dollar’s exchange‐rate value did not appear as one of the six metrics on “Bernanke’s Dashboard” — the one the Chairman used to gauge the appropriateness of monetary policy.
Well, let’s take a look at what Mundell saw in the months surrounding the collapse of Lehman and the onset of the Great Recession. He observed a wild swing in the dollar‐euro exchange rate (see the table below). In the July‐November 2008 period, the greenback appreciated almost 24% against the euro. Accompanying that swing was an even sharper one in the price of oil. It plunged by 57%. Gold, too, had a sharp fall of almost 22%. And, consistent with Mundell’s supply‐side theories, changes in exchange rates transmit inflation (or deflation) into economies, and they can do so rapidly. Not surprisingly, then, the annual rate of inflation in the U.S. moved from an alarming rate of 5.6% in July 2008 to an outright deflation of 2.1% a year later. This 7.7 percentage‐point swing is truly stunning.
So, in terms of monetary policy, Mundell saw the obvious: the Fed was too tight — massively too tight. The dollar was soaring, and commodity prices were collapsing. Fed Chairman Bernanke saw none of this because exchange‐rates weren’t even on his dashboard. Alas, the Fed’s massive monetary squeeze and resulting unstable dollar ushered the economy into a recession.
Well, here we are again. Today, there is a great deal of strain in the international anti‐system. The dollar’s strength has ratcheted up emerging market pain. Indeed, emerging markets and commodities are under a great deal of downward pressure. And, several emerging market currencies — most notably Argentina’s peso — have collapsed, sending inflation soaring. It’s time to jettison the international anti‐system and go for stability
This earning season is not the only time corporations have shown concern for exchange‐rate instability and its associated risks. Back in 2017, I tasked two of my assistants, Zackary Baker and Cameron Little, with what was an onerous job. They read every annual report of the 100 largest U.S. Companies to determine whether the companies noted exposure to foreign exchange risk, whether they hedged those risks, and whether they quantified their foreign exchange losses.
As the chart below indicates, 100% of the largest U.S. companies indicated an exposure to foreign exchange risks, with 80% indicating that they quantified their losses. Its obvious: U.S. corporations should provide a strong coalition to support a new system that would ensure more exchange‐rate fixity and predictability.
So, what has to be stabilized? The world’s two most important currencies — the dollar and the euro — should, via 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 obliged to maintain this zone of stability by defending a weak dollar via dollar purchases. Likewise, the U.S. Treasury (UST) would be obliged to defend a weak euro by purchasing euros. Just what would have happened under such a system (counterfactually) since the introduction of the euro in 1999 is depicted in the chart below. When the euro‐dollar exchange rate was less than $1.20 per euro and the euro was weak, the UST would have been purchasing euros (in the 1999 — 2003 and the 2014 – 2019 periods). When the euro‐dollar exchange‐rate was above $1.40 per euro and the dollar was weak, the ECB would have been purchasing dollars (in some of the 2007–2011 period).
Stability might not be everything, but everything is nothing without stability.