The US dollar has been so resilient for so long that most commentators cannot conceive of circumstances in which it would experience a sharp correction. Foreign demand for US assets remains so strong that there is little reason for investors to lose faith in the short term. But once the US presidential election is over, confidence could be tested by a variety of policy surprises. These risks centre on the traditional uncertainties associated with presidential transitions and the emergence of a multi-billion dollar federal budget surplus. Together, they set the stage for changes in tax and spending policies that could alarm both the Federal Reserve and the foreign exchange markets. The first risk is that the next White House administration will introduce many new people into policy-making positions. This lack of experience could create a constant risk of ill-judged comments about exchange rate policy or some other important issue which could surprise investors.
It has happened before. In the early days of the Clinton administration, Lloyd Bentsen, the new Treasury secretary, held a press conference at which he suggested that he would not resist a dollar devaluation because of its potentially benign consequences for exports. The result was an immediate 10 per cent devaluation of the dollar against the yen. The danger of amateurish political appointees making disruptive comments exists with both parties, but it is a potentially greater risk for a Republican administration for two reasons. First, George W. Bush's team would include no-one from the current Treasury, whereas a Democrat administration would probably retain some officials. Second, Mr Bush may appoint people from Texas, where he is currently governor. Texas has played a unique role in modern US financial history. Since the 1970s, there have been four major dollar devaluations. Three occurred under Treasury secretaries from Texas (John Connally, James Baker, Lloyd Bentsen). New York Treasury secretaries produce dollar rallies (Donald Regan, Nicholas Brady, Robert Rubin).
If he wins, Mr Bush should avoid the risk of history repeating itself by appointing someone with a grasp of the global financial market. The second great risk posed by the presidential election is that it could set the stage for a clash between monetary and fiscal policy next year. The US currently enjoys such a large federal budget surplus that it will be impossible to prevent fiscal policy becoming more expansionary. The total surplus is projected to be $4,500 billion over the next 10 years, or $2,500 billion excluding social security.
Both parties want to boost public spending on a variety of discretionary programmes that have been squeezed since 1991. The Republicans also want to enact a major income tax reduction, while the Democrats are offering selective tax cuts. The problem is that Mr Alan Greenspan, chairman of the Federal Reserve, has cautioned against fiscal expansion in an economy already at full employment. If the next administration disregards his warnings, the odds are very high that Mr Greenspan would increase US interest rates by a half or one percentage point. In addition to the risk of inflationary overheating, Mr Greenspan is also concerned at the size of the US current account deficit and the danger that fiscal stimulus could increase it further. During the late 1990s, the US private savings rate fell sharply as the government built up large surpluses. If the government now reduces its surplus without any offsetting change in private savings, the current account deficit would easily expand to 6-7 per cent of GDP.
The third risk posed by a monetary/fiscal policy clash is that the Fed will be more vulnerable to political intimidation during 2001 and 2002 than at any other time in American history. If Mr Bush becomes president, there could be four or five potential vacancies on the Federal Reserve board during the next 12 months - the largest number to arise in a single year since the Fed's creation in 1914. The creation of so many potential vacancies will pose a unique challenge for the next administration. It is always difficult for the White House to recruit competent people for Fed governorships: the confirmation process is cumbersome and potentially nasty; and the salary is only $136,000. But next year, the recruitment challenge could be even more daunting if the next administration decides to seek out governors who would not challenge a policy of tax cuts and fiscal stimulus.
The markets believe that Mr Greenspan is so powerful that no one would dare to question him, but it is important to remember the experience of the Fed's other Olympian chairman, Paul Volcker, in 1986. He had been very critical of the Reagan budget deficits, and the administration responded by appointing a variety of supply-side economists to the Federal Reserve board when illness and death created vacancies in 1985-1986. The new governors then lobbied for an interest rate reduction, which Mr Volcker opposed. He was so angry that he nearly resigned, but the dissidents reached a compromise which set the stage for a co-ordinated global interest rate cut. Mr Greenspan is so collegial that it is difficult to imagine him having so direct a confrontation, but the fact is the appointment of several new governors could compel him to alter the conduct of monetary policy.
The US economy is in such rude health today that it is difficult to imagine any political event blighting its prosperity.
The presidential candidates are naturally focused on how their fiscal proposals will be received by the electorate, not the global financial markets. But at some point investors will have to form a view about how potential changes in fiscal policy arising from the multi-trillion budget surplus will influence the Fed, the US current account, and confidence in the dollar. But these questions will undoubtedly form the next great challenge confronting the world's financial markets after November.
David Hale is chief global economist at Zurich Financial Services Group Dollar not euro set for major decline, page 6
