The Road to a Lower Dollar Paved with Good Intentions...

By Jack Crooks,
Currency Director and Editor of Crooks Currency Options and Crooks on Currencies.

Whenever I hear politicians say they are regulating something to "help me," I automatically expect to pay for their "help."

It would be more efficient if the meddling politicos just left the free market alone. But, the Nanny State overseers just can't help meddling. It's in their nature. The latest salvo of compassion for "victims" comes from U.S. House of Representatives Member Barney Frank (D-MA), the chairman of the financial services committee.

Mr. Frank has decided it's time to punish, or should I say, "regulate" mortgage brokers - as if they aren't "regulated" already. Apparently he thinks he can do better. He wants to help all those "victims" of "predatory" lending.

But, as Samuel Johnson once quipped, "The road to hell is paved with good intentions." And in this case, Mr. Frank's good intentions could hurt U.S. capital markets and the dollar.

How can regulating mortgage brokers hurt the U.S. dollar? It's because we live in a world where currencies are not valued on their intrinsic qualities (because nothing tangible backs up currencies anymore).

So instead, a currency's value is based on relative global demand. The major currencies of the world are free-floating against one another. Their relative value (dollar versus the euro for example) flows from the relative demand for one currency against another. When more capital flows to a particular country relative than another, that country's currency goes up in value. The popular one wins - just like a beauty contest!

The key to maintaining a currency's value over time is to ensure the country that uses that currency remains attractive for international investors. Fortunately for the U.S. dollar, the U.S. economy has attractive capital markets. For many years, the U.S. capital markets have been the largest, most efficient, and highly competitive compared to its global rivals. And money flowing into U.S. capital markets has been a major support for the U.S. dollar - and has likewise helped keep domestic lending rates low.

Many investors (and apparently politicians) take this for granted. For a while now, they've all thought "where else would investors go?" Well, now that view is changing quickly. And I think this is a major threat to the long-term stability of the dollar. But politicians don't seem to quite grasp this fact. Here's why...

Over US$2 trillion in mortgage backed bonds were sold in 2006, according to the Securities Industry and Financial Market Association. And a quarter of that amount was linked directly to the U.S. sub-prime mortgage market. In short, Wall Street created and sold a whole bunch of securities to international investors that generated a bunch of capital flow into the U.S.

Yet, Mr. Frank & Friends want to dig their regulatory claws into this fertile source of capital.

Mr. Frank told the Financial Times last Thursday, April 12: "It is no part of my concern whether investment banks make money [though he likes their campaign contributions]...the purpose of housing finance is to get people in houses, not to finance the U.S. financial markets."

It can be argued whether or not Mr. Frank is right or wrong. He may be driven by good intentions. But the result is the same. Regulating the finance industry adds to the growing belief U.S. capital markets are losing their competitive edge just as the European capital markets are getting seriously into the game. Just consider these points:

More company initial public offerings are now done in London and Hong Kong than New York.

For the second year in a row in 2006, there were more international bonds issued in euros than in U.S. dollars.

For the first time since World War I, the total value of all European stock markets was bigger than those in the US in terms of total capitalized value (as of April 6th 2007).

The world is beginning to realize European capital markets are fast becoming a viable alternative to the United States. And that means Europe could increasingly look better to international investors as a place to send capital.

Let's hope our politicians don't kill the goose that laid the golden egg as they attempt to deal out blame for the real and perceived abuses in our financial system.