Why does the US dollar continue to strengthen?

Source: Zhou Ziheng

Challenges facing the U.S. economy

The U.S. debt-to-GDP ratio has exceeded 130%, the highest level in history. Research shows that high debt levels constrain economic growth and can lead to defaults or extreme inflation. Since the U.S. can print money, the likelihood of default is low, but there is a significant risk of inflation, which could cause the currency to depreciate significantly.

Economic growth is weak, and fiscal and trade deficits are out of control. Although the unemployment rate is as low as 3.5%, approximately 8 million to 10 million people aged 25 to 54 are not participating in the labor market. The labor force participation rate has fallen to 62% from 70% in 2000, and if those not seeking work are included, the unemployment rate is likely to be close to 10%, close to recession levels.

Why is the US dollar still strong?

The reason the dollar remains strong despite a weak economy is the “plumbing” of the international monetary system. In 1980, Walter Wriston (a famous 20th century banker and inventor of negotiable certificates of deposit) explained that the monetary system is a closed loop. Funds are withdrawn from the bank to buy gold, and the seller deposits the money back into the bank. The funds do not disappear, only the exchange rate or interest rate is affected.

The Eurosystem and the Dollar Shortage

The key to the strength of the US dollar lies in the global euro (Eurodollar) system. The euro market relies on interbank lending, and if the money supply shrinks, it will trigger a financial crisis. Currently, the world is facing a shortage of US dollars. Although the Fed's balance sheet has increased from $800 billion in 2008 to over $7.5 trillion in 2020, and M1 has grown faster, this money has not effectively entered the economy.

The Federal Reserve creates M0 (base money) by purchasing securities, but most of these funds are deposited back to the Federal Reserve as excess reserves and do not flow into the real economy. M1 and M2, which truly drive the economy, are created by commercial banks through lending or purchasing securities. The money creation capacity of commercial banks is comparable to that of the Federal Reserve, but the impact of M0 is limited. A quadrillion of derivatives in the banking system would need to be backed by 7 trillion in M0 or 24 trillion in M1, leading to a shortage of U.S. dollars.

Conclusion

The strength of the US dollar does not stem from the strength of the US economic fundamentals, but from the structural characteristics of the international monetary system. The closed loop of the Euro system and the global shortage of dollars jointly support the status of the US dollar. In the future, we need to pay attention to changes in debt, inflation and the labor market to determine the sustainability of the US dollar trend.