On May 30, Henry "Hank" Paulson was nominated to succeed John Snow as US
treasury secretary. During John Snow's reign the US dollar lost 18% versus the
euro and 46% when measured against the price of gold. Can Paulson stop or
reverse the fall of the dollar? And will he?
Paulson is the outgoing chairman and chief executive officer of Goldman Sachs,
a prestigious investment-banking firm. Paulson has a trading background; the
investment bank's trading unit has become its most profitable division under
his leadership.
He is also known as someone who does not let himself be
pushed around. Whereas Snow and his predecessor Paul O'Neill had little
authority, except to promote the Bush administration's policies, there is a
widespread perception that Paulson only accepted the job after being promised
that he would be allowed to be an active participant in shaping policies.
Most commentators believe that persuading Paulson to accept the nomination has
been one of the best moves of the administration of President George W Bush so
far. But will this step be enough to cure the United States' trade and fiscal
deficits? Let us examine how Paulson could influence a couple of key parameters
that put the dollar most at risk.
We focus on the current-account deficit, which exceeded US$800 billion, or
about 7% of gross domestic product (GDP), in 2005; foreigners need to finance
the current-account deficit by buying more than $2 billion worth of
US-dollar-denominated assets every single day. How can the current-account
deficit be alleviated? Key ways include increasing domestic savings; lowering
domestic consumption; increasing foreign consumption; or increasing foreign
investments in the US.
Increasing domestic savings
Paulson has favored tax cuts to stimulate the economy, but he also favors
fiscal restraint. He may have been hired to increase pressure on Congress to
cut spending to get the budget deficit under control. Unfortunately, as an
unelected official, it is doubtful he can influence a Congress run by
voter-conscious politicians as much as he could influence "profit-conscious"
traders and bankers. The "discretionary" budget is rather small, and depending
on what your political persuasion is, if you live in the US you may think that
many essential programs have already been cut to the bone.
Paulson will likely be more successful in shaping spending policies than his
predecessors, but we should not expect him to persuade the government to cut
drastically, for example, its military budget. Let us also not forget that the
Bush administration is more or less a lame duck already; it is difficult to
envisage radical reforms. If nothing else, he might be able to persuade the
Bush White House - which has yet to veto a bill - to veto an over-bloated
budget. Also, Paulson is known as an environmentalist and might conceivably be
able to convince the administration that "green" policies can be good for
business.
Lowering domestic consumption
Promoting reduced consumption as a way to reduce the current-account deficit
has never been popular in Washington, as it seems political suicide. However,
unless accompanied by higher real income, higher savings tend to imply lower
consumption (or lower government spending).
The Federal Reserve has a bigger role to play in reining in consumption by
tightening available credit; but an analysis of this issue would go beyond an
analysis of Paulson's ability to save the dollar from falling further.
Increasing foreign consumption
If those outside the US only spent more, the United States' current-account
deficit wouldn't be so huge. There are signs that, indeed, both Europe and Asia
have been spending more, but will this effect be sufficient to impact the huge
imbalances? And, more important, as Asian consumers increase their appetites,
what will they buy that is imported from the US? Even a lower dollar will not
resurrect the United States' low-end manufacturing industries.
Having said that, it is not impossible that Paulson could make a real
difference when it comes to trade. He has traveled to China more than 70 times
and is known and respected throughout the world.
We at Merk Investment LLC have been rather concerned that increased
protectionist sentiment will make the adjustment process for the dollar more
painful, because it would punish those businesses that have been able to adapt
to globalization. Paulson could play a useful role here, as a figure who can
communicate the real pros and cons of globalization; he could potentially
contribute a great deal to helping politicians at home and abroad understand
the real issues, so that populist ideas can be held at bay.
As far as the dollar is concerned, rising protectionism is a major risk because
of the United States' current dependence on foreigners to buy
US-dollar-denominated assets to keep the dollar from falling. Many misguided
policies in recent years have led to a disillusioned US public that is working
harder than ever while making less in real terms; it is all too easy to blame
China and other emerging countries for the challenges that the US faces. What
the country needs is someone who can apply pressure abroad where pressure is
due, but also apply pressure at home to strike a balance.
Should things come to a crisis in the derivatives markets, Paulson knows these
markets and industry participants well. While we doubt Paulson may be able to
reverse the trend of the falling dollar, he can contribute to making its
decline orderly.
John Snow's talk about a "strong-dollar policy" was - at best - a joke among
traders and journalists. A great deal of pressure is being applied to China and
other Asian states to appreciate their currencies. We have been arguing that
these countries are extremely reluctant to allow such appreciation, as it would
cause a double whammy to their inflated economies if accompanied by a slowdown
in their primary export market, the US economy. Paulson understands the
structural issues China's banking system is facing, and may be able to lobby
for more understanding and patience on the US side, while applying pressure at
the right levels in China to accelerate reform.
Some cynics have pointed out that Hank Paulson may be making the best trade of
his career by accepting the nomination. Paulson took Goldman public, but has
never sold any shares; as treasury secretary, he may be forced to sell out of
his position. If indeed rougher times are ahead, this would be the most elegant
way of liquidating his investment; had he sold out as CEO of Goldman, it would
have caused quite a stir.
Taken together, the nomination of Paulson is a positive for the US dollar. But
we doubt it is enough to alleviate the pressures on the currency that may
persist.
Axel Merk is the founder and president of Merk Investment LLC and the
portfolio manager of the Merk Hard Currency Fund,
a no-load mutual fund that invests in a basket of hard currencies from
countries with strong monetary policies assembled to protect against the
depreciation of the US dollar relative to other currencies.
(Copyright 2006 Merk Hard Currency Fund. Used by permission.)
