Today’s comment is by Jack Crooks, our Currency Director and editor of both The Money Trader and Crooks on Currencies.

Dear A-Letter Reader:

The upcoming election is front and center in the minds of currency investors right now. They’re all wondering whether the election will bring good or bad news for the dollar, particularly if Democrats win control of Congress. I personally think a Democratic victory would have a negative effect on the U.S. dollar, but not for the reasons you might think. 

The media is speculating that a Democratic Party victory would result in higher taxes and new spending on social programs, which are supposed to spring up like weeds if the Democrats win. Therefore many commentators assume that the U.S. economy will be less competitive and attractive to international investors. And, they predict this will be bad for the dollar. I don’t want to get into the politics of their argument. But I will say they’re right about the dollar’s direction (down), but they’re right for the wrong reasons. 

“Gridlock” will likely become the watchword if Democrats gain control of Congress. That’s because, if the Democrats do win, their margin of control will likely be slim. Plus, we have a Republican president who will likely muster the will to wield a six-year old veto pen that’s still filled with ink. In my view, because of the gridlock, government spending may actually be reduced, or at least grow more slowly over the next couple of years. We could see a tightening of U.S. fiscal policy.

You may believe tighter fiscal policy is good for the dollar while loose fiscal policy is bad.  If so, you’re not alone. We’ve been conditioned to believe that by the financial press that really doesn’t quite get it. Reality is quite different.

When you think about government spending and its impact on the dollar, it’s key to link that thinking with the monetary side of the equation (monetary policy). Why? Because this theorem has played out many times over the years: 

“A country’s currency will tend to rise on loose fiscal policy and tight monetary policy and fall on tight fiscal and loose monetary policy.”

This is a theorem first postulated by George Soros (the global macro trader, not Soros the political gadfly). I first saw this idea back in 1987 when reading Mr. Soros’ excellent, yet esoteric, treatise entitled, The Alchemy of Finance. And it fits perfectly to explain the massive bull-run in the dollar from 1980 through 1985.

At that time, the dollar rocketed upward when newly installed Federal Reserve Bank Chairman Paul Volcker instituted an extremely tight monetary policy, jacking interest rates into double-digits to fight inflation. And on the fiscal side, the U.S. government was racking up huge deficits (or at least what was considered huge at the time). Volcker’s interest rate increases drew in overseas deposits to the dollar. President Regan’s deficits, due in large part to defense spending, lubricated economic growth. As growth momentum rolled along, the additional reserves on deposit helped support loan growth to bolster faster economic growth. It was a self-feeding dynamic benefiting the dollar.

We could end up with a self-feeding negative dynamic for the dollar if Democrat control of Congress. Tighter fiscal policy will drain money from the economy. If so, Fed Chairman Bernanke might attempt to counteract such a reality by aggressively loosening monetary policy. That means we’d have the exact opposite situation happen: tight fiscal policy and loose monetary policy. And according to Soros’ theorem – this equals bad news for the dollar.

If this scenario plays out, you can bet a lot of international investors will high tail it out of the buck. Slowing economic growth and falling interest rates isn’t why they’re here. 

JACK CROOKS, Currency Director
On behalf of The Sovereign Society