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As election euphoria
settles and the "fiscal cliff" approaches, what are the
implications for the dollar? Even as federal deficits may be unsustainable, stocks
and bonds are up, and while the dollar may have resumed its long-term
downward trend, the greenback has hardly fallen off a cliff. We look at how
different tax policies might affect the U.S. dollar.
In our assessment, the fiscal cliff, that is the
looming simultaneous tax increases and spending cuts, is mostly a
distraction. It's a distraction because, as significant as the short-term
impact on GDP may be, "going over the cliff" does not solve our
long-term fiscal problems. Indeed, we might as well call it European style
austerity, as before factoring any slowdown induced by the cliff itself, the
U.S. would continue to face a deficit exceeding 3% of GDP. More importantly,
Medicare reform, in our view key to long-term budget sustainability, remains
elusive.
The most attractive attributes of the dollar may
well be its liquidity. A side effect of issuing record amounts of debt is
that central banks have a place to deploy their dollar reserves without
impacting markets too much. However, the Federal Reserve (Fed) may be
crowding out other investors, as it gobbles up an ever-growing chunk of
federal debt, in an effort to keep down U.S. borrowing costs. Still, the Fed
has shown its willingness to provide liquidity in times of crisis, providing
comfort to many.
And while we take it for granted, the ability to
take one's money out of the U.S. is also a key reason why investors put money
into the U.S. The best thing that could happen to global financial stability
is if emerging markets opened their capital accounts and developed their
domestic fixed income markets, making them less dependent on U.S. dollar
funding. Instead, policy makers from Brazil to Switzerland that are afraid of
speculative inflows impose roadblocks, then engage
in ill-fated efforts to manage the fallout from their policies. Countries
might be better served preparing their economies for a world where the dollar
is no longer the only game in town, rather than deploying billions to provide
the illusion of a world order that we believe won't come back.
Like any asset, currencies are driven by supply and
demand. Investors buy U.S. dollar denominated assets if they believe they get
a worthy return. Because the U.S. has a current account deficit, the
greenback has a continuous uphill struggle: foreigners must buy U.S. dollar
denominated assets to pay for U.S. deficits: all else equal, the current
account deficit is exactly the amount of U.S. dollar denominated assets
foreigners must buy to keep the dollar from falling. In turn, the dollar may
benefit when the U.S. is an attractive place to invest in; in many ways, this
explains why the U.S. is always in search of growth. In contrast, the
Eurozone's current account is roughly in balance and as a result austerity
and any accompanying economic slowdown, even select government defaults, are
not ex-ante euro negative.
Conventional wisdom suggests low taxes and low
regulatory overhead attract investment. To an extent, we agree, but even more
important than tax rates and lax regulations may be clarity on taxes and
regulations. Businesses want to know what the rules are going to be. Silicon
Valley, for example, has long been able to attract capital despite high tax
and regulatory burdens. Similarly, Europe has some very competitive
businesses despite the tax and regulatory overhead. Ultimately, regulations
increase the barrier to entry, protecting large established firms, but
stifling innovation from small business. High taxes may foremost influence
new capital deployment. Before someone thinks we praise high taxes and
regulations, let's keep in mind that Silicon Valley has increasingly been
losing out to competition from other states. The challenge is that the
backlash from high taxes and regulation is a slow one, giving policy makers
the illusion that their policies may not be causing any harm. In the context
of current U.S. policies, the uncertainties created by Congress relating to
the fiscal cliff are not helpful. Neither is it helpful that massive
regulatory initiatives, from healthcare to financial "reform"
create more questions than they answer; the only certainty is that adherence
to the new policies will create substantial cost.
Competition is not national, but international.
Whereas the French try hard not to get any investment dollars from abroad,
Singapore has an active outreach to attract businesses. What Singapore
understands is that resting on one's laurels is not an option. Similarly, the
U.S. would do well not to ride on past glory when investors sought out the
U.S. dollar because of prudent policies. Offering "the most liquid
markets in the world" alone is not a long-term recipe for success. In
our view, it is also not helpful for the U.S. to rely on the greenback's
status as a reserve currency, rather than fostering policies that promote its
status as a reserve currency.
One tax policy with significant dollar implications
is the taxation of earnings that are repatriated by US companies. While it
may make good politics to talk about corporations paying their "fair
share" (one of the most abused and overused catch phrases in politics),
it should be apparent that punishing those taking money back home makes
little sense from a policy or dollar point of view. Cash rich companies
borrow money in the U.S. because much of their cash is sitting abroad. The
periodic lowering of the tax is also counter-productive, as it encourages
more hoarding abroad; just as with any policy, predictability is key: abolishing the tax on repatriated earnings is, in our
assessment, one of the more prudent policies that could be pursued to support
the greenback.
More generally speaking, policies that foster
savings and investment may be needed to reduce the dollar's vulnerability by
reducing the U.S. current account deficit. Trouble is that such policies may
impact short-term growth and, as a result, tend to make for good speeches,
but rarely are implemented into actual policies. The most obvious here is to
tax consumption with a national sales or value added tax and reduce or
replace income and capital gains taxes with revenues from these new taxes; an
energy tax falls into the same category. Democrats don't like it because they
consider it a regressive tax; Republicans don't like it because they think
such a tax would give the government a license to spend. The fair tax
movement (again, fair!) that seeks to abolish the income tax system with a
national sales tax may have all the right motivations; but we shall caution
that our understanding of policy dynamics suggest that we would end up with
both income and national sales tax should the idea gain traction. It is, by
the way, possible to structure a national sales or
value added tax to be progressive: Vic Fuchs, Professor Emeritus at Stanford,
has promoted a value added tax where proceeds are used to pay
for national health care coverage. By clearly identifying and capping
benefits, high spenders would pay more into the system than they receive.
This may well be a back-door way to introduce a national value added tax at
some point. And once introduced, it may well morph into something bigger.
As it stands, however, the U.S. tax system is
hopelessly out of touch with that of the rest of the world. Europe has
learned that individuals can be taxed rather highly before they move, but
corporations must be lured with low taxes. As far as the dollar is concerned,
we consider the current tax system a negative for the dollar; prudent tax
policies could promote the dollar. But the tax system itself may not trigger
a "dollar cliff". The bigger concern is on the spending side, as
any tax system may fail at some point when spending far exceeds revenue. The
fiscal cliff discussion is, in our assessment, about merely tweaking
spending. Meaningful entitlement reform is, in our view, the most important
factor driving long-term fiscal sustainability.
However, as Europe has shown us, the only language
policy makers appear to understand is that of the bond market; as long as the
bond market lets policy makers get away with excessive spending, we see
little chance entitlement reform is tackled in earnest. As such, the risk of
a dollar cliff may stem from the bond market acting up to provide
"incentives" for reform. Because the U.S, unlike Europe, has a
current account deficit, the dollar may be far more vulnerable should the
"bond vigilantes" impose reform. "Bond vigilantes" is a
term used to refer to a bond market selloff that imposes reform. On that
note, we don't need horrible news for such a selloff to happen: good news
might do the same. Should the economy recover, the bond market may turn into
a bear market. In such an environment, foreign investors that historically
favor U.S. Treasuries might reduce their holdings, causing downward pressure
on the dollar. In our assessment, the biggest threat to the bond market - and
with that to the dollar - is neither good nor bad news, but a return to
historic levels of volatility in the bond market. A lot of investors that
have chased yields might all run for the exit at once should sentiment spread
that U.S. bonds might be a bit pricey.
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