The US dollar never collapses, but why

Episode # 21 from August 5th, 2020 - The ineptitude of the U.S. government threatens the pioneering role of the U.S. dollar

The forecast becomes certainty: The second quarter showed how severe the economic consequences of the corona pandemic really are. At the same time, the US government's chaotic reaction to the pandemic and economic crisis is also weakening the US dollar more and more - and why gold is not always safe.

Eric Graydon:
Today we want to tackle two major topics again. First of all the sad certainty that we now have in terms of the "effects of the Corona crisis on the second quarter of 2020" and then the amazing increases in value that we have seen in the past few weeks for the euro and then also for gold, and what that means to us reveals the relative competence of the US and European response to the pandemic.

Last week at this time it was still a forecast, now we have certainty: The second quarter of 2020 is likely to be the most brutal economically that the globe has ever experienced. Germany's economic output fell by 10.1 percent, that of the euro zone by 12.1 percent. The USA lost 9.5 percent, with the not particularly helpful figure of minus 32.9 percent making the rounds - but more on that in a moment. In any case, there are values ​​on the screen that can hardly be surpassed in terms of horror. Mr. Fratzscher, maybe let's just start with that. In our last episode, you predicted a 10-15 percent contraction in the German economy in the second quarter. We are now seeing the bottom line is "only" 10.1 percent. Are you relieved?

Marcel Fratzscher:
I'm a little relieved that the economic figures are not as bad as I feared. But you certainly can't be really relieved or happy, because we discussed that last week: 10.1 percent in a single quarter, that's as strong outside of war times as it has been since 1933 and that's something that seldom happens, a massive slump. Yeah, I'm a little relieved because it could have been worse. At the same time, one shouldn't say now: we breathe easy, everything will be fine, because we could face even more difficult times. But for now, I think you can take a deep breath. In the third quarter, July, August and September, we are currently expecting growth in Germany of three percent. That's very neat, even for a single quarter. You get the feeling that if this goes three percent more every quarter, then at the beginning of next year we will be back at the level where we were before the crisis. You can't do it like that. That would be too good to be true.

But first of all it is good news that the economy has not slumped even more, but then you have to look carefully, because the most important reason why the German economy has not slumped is the German state. When we calculate such an economic performance, we usually look at four different components to make it as simple as possible. Let's take a look at each other: What happened to private consumption? In Germany it has "only" shrunk by ten percent. So that's what we as consumers spend, what we buy. Sure, many things change little, I still have to buy food, but for example, many have not been able to make major purchases.

It is most dramatic of all for exports. That is the second element. We see that they have slumped by 20 percent. One fifth fewer exports in the second quarter compared to the first quarter. The companies invested around 15 percent less in terms of investments. How do you get the ten percent when we have a 20 percent drop in exports, 15 percent for investments and private consumption with ten percent? The answer is: the state. The state has, of course, massively expanded its spending and supported it through tax cuts or transfers. And that explains why it hasn't gotten any worse. So I think that gives it a bit of a balanced picture. Yes, it's dramatic, but it's not quite as dramatic as feared. But in the end it is the state that has fired all over the place here in order to prevent worse things from happening as best it can. And that's why you have to assess that. The state can of course do something like that again: Increase spending again and lower taxes in the future. But he still won't be able to do this every quarter. That is also part of honesty. The way out of this hole - 20 percent fewer exports - is of course a long way.

Eric Graydon:
Then it fits very well that we now look again at the neighbors to whom we are trying to export. Some of our neighbors have suffered significantly worse losses than Germany - Italy, Spain, France. However, it looks particularly bad in Spain. Economic output there fell by 18.5 percent in the second quarter - almost a fifth. Of course, the country had to suffer especially - just like Italians - from the effects of the Corona crisis. Tourism, which is so important for Spain, is now facing an uncertain future, to put it mildly. How many worries do we have to worry about Spain from a pan-European perspective?

Marcel Fratzscher:
We have to worry a lot about Spain because, even before the crisis, Spain was not necessarily very robust - nowhere near as robust as Germany. Spain still suffered from the global financial crisis of 2008 and 2009, which hit Spain, but also Italy, hard. (Youth) unemployment was still very high before the crisis. Many companies haven't really recovered yet. In addition, Spain also had major problems with its own banks back then. Spain had to spend a lot of money to recapitalize it again - similar to Germany, by the way. And the concern now is that such a severe economic slump will also affect the banks in Spain and that such a downward spiral will set in motion: companies produce less, many companies go bankrupt as a result, the banks are affected and grant fewer loans the private sector, i.e. to us consumers or to other companies. This means that economic output will collapse even more. And the state in Spain is trying to do a lot there too, but it is not as capable of acting as it is here in Germany. Debt there is high, well over 100 percent of economic output. And that is a bit of a horror scenario that such a severe slump then sets a downward spiral in motion and that is why it is so important that the Spanish government - with the help of the Europeans - reject it.

Eric Graydon:
Then let's take a look at the USA, perhaps first for the sake of classification: After the growth figures in the USA were published, you read this figure of 32.9 percent, by which the US economy has shrunk annualized. If you don't know what to do with this term, it sounds like: Wait a minute - has a third of the US economy just fizzled out? How does this number come about?

Marcel Fratzscher:
Yes, we economists always like to think in terms of annual figures: we always like to extrapolate things over an entire year. In the USA, economic output slumped by 9.5 percent in the second quarter, almost as much as in Germany. And if you now extrapolate that annualized to a year, then you say: What would happen if the US had 9.5 percent less economic output every quarter? Then you would come to this ominous 32 percent. And it's humbug, of course, because at least I hope the American economy doesn't shrink 9.5 percent every quarter. It might not look good in the US in the third quarter, you have to be honest, but these numbers, around 32 percent, should not be taken seriously because they are ultimately such a hypothetical calculation. What matters is the 9.5 percent. That’s bad enough.

A comparison with Germany, many are now taking this as an opportunity to say: Look here, the Americans got through the crisis better than we Germans, they only shrank 9.5 percent, we Germans over ten percent here! And that shows a bit that you have to be very careful with these numbers. Because the question is always: what would have happened if ...? What is good performance? What is comparatively good to other countries? And as I just said, economic output in Germany plummeted 10.1 percent. But the most important reason for Germany is that we have an extremely open economy. Exports, which make up about half of Germany's economic output, have slumped by 20 percent, or twice as much. And the USA is completely closed and has very few exports - just under 15 percent, i.e. just under a seventh of its own economic output. And actually, according to all our forecasts from April / May, they should have done significantly better than they have now. And the reason is the chaos in the US that we are seeing: that there are no rules there. Everyone does what they want, now spoken very flippantly. There really isn't a strategy on how to deal with the pandemic. And as I just said, in Germany we should have been hit a lot harder if we weren't, depends on the very decisive intervention of the German state with two huge economic stimulus programs. The US has fared much worse than we had previously expected because the state ultimately did not act very wisely and because there is still not really a coherent strategy. People are afraid, companies are extremely insecure - even more insecure than here. And that means that an economy like the USA, which is relatively closed, should have done significantly better in this crisis so far.

"What is happening in the US is dramatic"

Eric Graydon:
If we look at that 9.5 percent in the US, what does that tell you about the US's ability to pull itself out of this crisis? For the Germans, these stimulus packages were of crucial importance. We are now seeing in the USA: an agreement on a further stimulus package has still not been reached. The expansion of unemployment benefits, which is very important for many Americans, expired last week - a replacement, as I said, is not yet in sight. What do you think are the chances that this country will be able to free itself from the crisis in a timely manner or at least at the same pace as Europe, for example?

Marcel Fratzscher:
What happened in the United States is dramatic and dramatic in the sense that so many political mistakes have simply been made. And for me the example of the USA is one of how you can actually do so much politically wrong with a strong economy that you do a lot of damage to your own country by not closing early, by not imposing a mask requirement for everyone at an early stage and also makes sure that it is adhered to, that you don't have a clear strategy on how to bring the numbers down as quickly as possible. And that leads to panic. That leads to a lack of trust. For me, the US example is one of how not to deal with such a crisis. And if we are now thinking about a second wave in Germany, there is heated discussion here at the moment: Can we even afford to close shops and companies again? Isn't that completely wrong? Then I like to refer to the USA and say: Look what happens if you don't try to stop this virus early on. Then a country - also like the USA - and an economy fall into a deep hole and we absolutely want to avoid that.

Eric Graydon:
That you are not completely alone with this perspective can be seen very impressively, among other things, from the values ​​for the currencies. If you now compare the euro and the US dollar with one another: The dollar is increasingly losing value, while the euro is increasing more and more. Where does it come from?

Marcel Fratzscher:
The currencies reflect expectations about the future. The value of the euro or the value of the US dollar reflects what people expect and how the economy in their own country will fare in the future, that is an important reason. I will come to a second reason in a moment, which is now specific to the United States and the US dollar. In other words, people no longer have that much confidence that the American economy will develop as well as the European economy as it would have been expected. I have just mentioned: economies that are open and export a lot should actually be hit harder. The currency should actually devalue here. So actually one would have thought that the opposite would happen, the US dollar also appreciated against the euro - but it didn't.

Ultimately, the value of the currency is a bit of a confidence mark. It says something about the trust of people, including investors, of the economy, of economic policy and the outlook for a country's economy. And it shows that people are more skeptical about the USA than about Europe. We have just talked about Spain: Of course for the euro zone, for the 19 countries that have the euro, Germany is of course by far the largest economy and accounts for around a third of the total economic output. And, as I said, Germany has come through the crisis relatively well so far. And many people simply have a lot of trust and say: Politicians in Germany manage it very well. Politicians did it better than most of the others and you can see that in the value of the euro, but of course also in the interest that the state pays on its debts. And they are still negative in Germany. To be precise, the German state gets 0.5 percent if it takes on debt for ten years. So the Federal Minister of Finance says: I need 100 million euros for ten years. He gets the money from the investors who are happy to give it to the safe German state and then have to pay the German finance minister EUR 500,000 in interest every year. So ultimately, these low government bond rates are a reflection of a relatively strong currency right now or a rising value of the euro. It's a great vote of confidence.

Eric Graydon:
But at the same time, of course, if you read through the comments on it, there is talk of the EU heads of state and government's approved € 750 billion package. This package is far from being adopted. That still has to go through the parliaments. There is still a lot to be done. And how long that will take is still a bit unclear. Isn't that relatively dangerous advance praise? What if investors let the euro rise because they believe that the EU is in a position to react as resolutely as this € 750 billion package now suggests? Isn't it to be expected that if that goes wrong, there could then be another dramatic depreciation of the euro?

Marcel Fratzscher:
Yes, of course the rising value of the euro and the low interest rates on government bonds are a vote of confidence in a good reaction, but also in the strong solidarity in Europe. I believe the package from two weeks ago that the heads of state and government said here: We want to help the weakest and hardest hit countries here, and we will do so, and with significant sums of money. That creates trust. If this trust is disappointed, then the euro will go down again. For a while before the global financial crisis, we had the value of the euro, at $ 1.60 for a single euro. So there the euro was very, very strong. They got a lot of dollars for it. Then it fell very, very much in the chaos of the European financial crisis in 2010 and 2011. It had fallen back to almost parity - meaning that for one euro you only got a dollar. The euro was now around $ 1.10 to $ 1.15. You can now get more than $ 1.20. This shows that the euro has increased in value. But it is not the case that the euro is incredibly strong if you compare it historically with the last 15 or 20 years, but rather that it is at a value where we economists say: That is a fair value. So what you can buy for one euro in Germany is roughly the same as what you can buy for 1.20 dollars in the US at the moment. So the purchasing power is about the same, so that's a fair value. That's why I'm a little more relaxed about it. Yes, the rise of the euro is a vote of confidence that Europe is doing some things right, but at the same time it is not the case that the euro is overvalued, that it is very strong. This is important because a strong currency always means that it is more difficult for exporters to sell their export goods abroad. Because they then become more expensive in the local currency when the euro rises. And that is particularly important for Germany.For German exporters, panic is not necessarily the order of the day, but I think we are still talking about a relatively moderate increase. Nevertheless: A rising currency is good for importers (for us consumers) because imports become cheaper and that is usually not so good for those who export and sell goods abroad.

Invest in gold? D rather not!

Eric Graydon:
You are now saying that you don't have to hang it all that high. At what point would you say that this would become a real threat to the recovery of the German economy?

Marcel Fratzscher:
Oh, I think we should still see a very, very significant increase. So if the euro were to rise to US $ 1.40-1.60 now, it would be really tough for many exporters. Because when companies do business with each other, it's not as if we went into business somewhere and said: What does it cost? And the shopkeeper could, if he wanted, change the prices every day and say: Oh, it has become more expensive today. Rather, very long-term contracts are often made. That means, as an entrepreneur, you say: I would like to sell my machines to Brazil and you have now ordered that and you will get the machine in nine months and that’s the price. And then you set the price today. That means what is happening in the economy today, the prices that are paid today for export goods were to a very large extent already set six months ago, a year ago or sometimes even two years ago. So very quickly a rising currency does not necessarily have an impact on the companies, on the exporters, but of course: If this continues, the euro continues to rise, which also continues over time, then sooner or later it could lead to significant losses for them Exporters come because if they want to sell their goods abroad and the euro is very strong, then they are less competitive. Then their goods will become more expensive abroad. That means that those of the competitors who do not produce in euros would be a little cheaper. I think we can be quite relaxed at the moment, but we should keep an eye on it and make sure that the euro does not rise too much.

Eric Graydon:
The US dollar is falling. Of course, the US dollar is still the global reserve currency. If this reserve currency loses value, what are the consequences for a global country like Germany? So is this something to keep an eye on? Or is it enough if we first say: No, we just look at our euro and see how it moves?

Marcel Fratzscher:
I want to briefly explain what it means that the Americans have a global reserve currency in the form of the US dollar. The former French President, Charles de Gaulle, once called it an "exorbitant privilege". They can get into debt in their own currency, everyone wants to hold onto their currency. The question is when we say in Germany now: I definitely want to invest my money, what do I do with it? Then I'll buy a government bond. So I give my money to the German state because I think that's the safest thing I can do. That is also the right thing to do within Germany. Seen globally: What are governments doing when they have money on the high edge? Have reserves? Companies that have surpluses or want to invest money? Where do you put it when you really want to be absolutely sure? And the answer is: you invest it in US dollars because that is ultimately the ultimate safe currency, the anchor currency. And you can see that in this crisis, too, not now against the euro, we just discussed that, but the US dollar has risen against many other currencies because many have said: Now are bad times, I don't want to take any risks, me park my money in the US, in US dollars and US government bonds. And that is this "exorbitant privilege". It doesn't matter, it doesn't matter, but it doesn't matter how irresponsible the American state is at the moment when it has the global reserve currency, the American government still benefits because there are no real alternatives to the US dollar. And the euro is, I want to say, the first competitor to the US dollar. The euro too has at least a regional but also a global role. Around 23 percent of the currency reserves that governments hold in reserves around the world are also invested in euros. Almost 70 percent are in US dollars, but around 23 percent are in euros. This means that the euro also benefits a little from the fact that, although it is not a global reserve currency, it is at least a regional reserve currency. And the question is always: Can the euro compete with the US dollar as a global reserve currency at some point?

The Chinese intend to do just that. Those who try to build their currency, the Chinese renminbi, into a global reserve currency, because having a global reserve currency does not only mean that they can finance themselves cheaply, but that also means concrete political power, because they ultimately force all companies or many companies force to carry out their transactions in this global reserve currency, because ultimately a lot of the money is then in this global reserve currency. Yes, I actually think it is extremely important that Europe also strengthens the euro as a global reserve currency, at least in comparison to the USA as a competitor. Unfortunately, the international role of the euro has lost a bit in the last 15 years. The trust of global investors has been lost and I think the point now is to catch up again, to say: Well, that's important to establish the euro as a global currency. What we have seen with the reconstruction fund, that the European Union can also jointly borrow, is also one reason why the euro is rising because investors have seen: Oh, look, look here. In the euro zone, in Europe, there is now also greater coordination of financial policy. That is important for a currency that wants to become a global reserve currency and strengthen itself. And here the trust has grown with it. A global reserve currency is a "safe haven" - and the Americans benefit enormously from this. And it would be wise if we Europeans also strengthen the euro.

Eric Graydon:
But what are the consequences if the global reserve currency loses value?

Marcel Fratzscher:
It is very important in an economy to have a safe bond, a safe haven, as I have just described with the German government with regard to the federal bonds. It is incredibly important that investors who say: I mustn't take any risks here with my money - many insurance companies say: They have taken out their life insurance or they want to get the money paid out next year, I don't want to take any risks - that's why So many are buying this safe bond. And when they have less safe bonds, as has happened right now in the US, people say, I need these safe bonds. And if the American government doesn't keep this up and confidence in the US dollar or US government bonds is lost, then there will be a lack of safe bonds. And that can lead to the financial markets becoming more unstable, so that many say: Oh, that is too risky for us with the USA. But where do we invest then? And that is a big problem of the international financial system that there are fewer and fewer of these safe bonds - also in Europe. For example, France has not had the top rating for a long time. So no longer the top assessment that one says: This really is the ultimate secure bond, because they now have 100 percent of an annual economic output as national debt. And that is why it is so important to have states that act credibly so that there is a safe haven. What that leads to when confidence in a safe reserve currency goes away is that investors are looking for alternatives.

Eric Graydon:
There is of course a classic of supposedly safe investments: that is gold. Now, for the first time in history, the price of gold has risen above $ 2,000. We are currently at just over $ 2,000 per troy ounce of gold. If you now do things that spoil the game, like taking inflation into account at historical highs, then the gold price was already higher, but not by much. In any case: what we are currently seeing in the gold price is extraordinary. What do these climbs tell you?

Marcel Fratzscher:
The sharp rise in gold tells me that people are afraid that investors, life insurance companies, banks, but also companies and private individuals will say: I don't really trust the American government that it is making a responsible economic policy here, that the American economy will be quick it comes out again that there could be faults there. That's why I want to invest my money even more securely than in US dollars and US government bonds. I go in gold. This is the ultimate safe haven - and that is what we are seeing right now. Ultimately, this reflects a loss of confidence and concerns about how the world economy will continue, that people say: well, the euro is not really an alternative for me either. It is not the case that the euro zone or the European Union now have a very good economic performance. They're fighting too. Then I'd rather go in gold than an alternative to currency.

Eric Graydon:
But it is of course also the case that large amounts of money have been lost in such cases in the past when betting on gold. If we look at the movements in the price of gold since the last euro crisis around 2011, the price of gold was sometimes very, very high. And as I said, if you factor in inflation, it's probably a bit higher than now. After that, the price was cut in half. To what extent is gold really suitable as a safe investment?

Marcel Fratzscher:
I would advise every layperson, every citizen who is not really very familiar with the financial markets, to go into gold, silver or other metals now, because these prices simply fluctuate so strongly. And if I'm not a professional, then it's simply an enormous risk for me because I don't know: will the peak continue to rise or won't it drop by 10-20 percent within a few days? And I have less of this risk with currencies. Currencies are more stable, at least the major currencies such as the euro or the US dollar. I have more stability and don't run the risk of losing a lot of money in a very short time. So I think it's an interesting phenomenon to talk about why the price of gold is so strong. That says something about trust, but I would now warn people not to say: Oh, that's a good idea, it's actually pure speculation. It can be explained, but it's still extremely unsafe.