The Dollar Falls

A few of you have asked what I think about the recent sharp decline in the value of the dollar. In general it’s a good thing. Let’s have more decline.

The problems we have with the dollar stem largely from the flood of money we have created to bail ourselves out of the mess the banks put us in last year. That was a necessary evil, but it unleashed a tide of dollars on the world. The simple laws of supply and demand imply that such a flood will inevitably reduce the value of the dollar. Each incremental issuance of US debt we make to pay our bills needs investors willing to buy them. Under the normal conditions of the last half century the US dollar and US debt has been a bastion for safety for investors. The demand for US debt has been steady because everything else is seen as more risky by comparison. So whenever there was a worldwide recession the US benefitted from an inflow of credit.

We became addicted to this inflow. So much so that we built our economy around being able to get other people’s money to pay for our own spending. Our trade deficit ballooned and has been negative for years – although today’s news is that it shrank a little last month. This was the central premise of the Reagan inspired fiscal policies we have pursued for decades. We were able to run trade and Federal budget deficits precisely because there was a steady stream of foreign investors who had spare cash and wanted to invest it safely.

In fact the existence of those foreign sources of cash is often used as a reason for our real estate bubble: were there no foreign cash we would never have had the money to inflate our house prices the way we did. This is the ‘savings glut’ argument some economists – including, at one time, Bernanke – to explain our bubble problems.

But all good things come to an end.

The world seems sated.

They have so many dollars in their investment portfolios that they are now getting concerned about having too many. So demand is ebbing.

Plus our economy has been exposed as being less reliable than people thought. Other economies are now in better shape and offer better returns. This also reduces demand for US debt.

The effect on the dollar is to depreciate its value. Dollars are so abundant that they are worth less than before. Especially when our interest rates are so low.

In general I think we should look forward to the dollar declining more. Most Americans won’t see much immediate impact. Our products will become cheaper when sold in foreign countries, so that will stimulate demand for American goods. Imports will increase in price and that would make things that are originally produced and priced in foreign currencies – cars for instance – more expensive. But anything that is produced and priced in dollars – oil being a good example – will not change in price in America. That means our trade balance should narrow and our domestic economy will grow a bit faster than it otherwise would.

One of the reasons the stimulus has been slower to percolate through our economy – it has worked, but could have worked sooner – is that it was designed to increase spending. To the degree that the spending was on foreign goods, the jobs the stimulus created were abroad not here. So a declining dollar helps prevent that exporting of jobs.

A more difficult problem, and one with profound long term political impact, is that the flood of dollars and the decline in their value has irritated enough foreign governments that they are actively discussing eliminating the dollar as the world’s primary trading currency. Plenty of commentators here treat this threat as shallow and temporary. I disagree: I think we ought to be very aware of the possibility of such a move. The impact on us would be severe.

Since oil and many other basic commodities are priced in dollars and not in the currency of the country producing them, anyone who is producing such things is getting hammered. The Third World is up in arms because of this. So are the big oil producers. Since this is the same group who feel aggrieved over trade conditions generally they are in the van of those demanding that the dollar lose its pre-eminence. They would prefer a stable currency, or possibly a ‘synthetic’ one made up of a mix of things such as the dollar, gold, and the euro.

But that argument is only just brewing. The point is that the days of the dollar being the world’s currency seem numbered because we have been profligate for thirty odd years and have not run a tight fiscal ship since Reagan cast us adrift in debt. You cannot keep printing money and relying on foreign sources of cash for ever. That was the Reagan way. Unfortunately we built our entire economy around foreign debt.

Throughout history, the world’s largest and richest nation has always been the world’s largest creditor. That was true in ancient Rome and it was true for the British in the 1800’s. It was true here as well up until Reagan. The post Reagan American economy is an historical anomaly: despite its wealth and power it borrows rather than lends to the world. It depletes its capital rather than adds to it. Eventually the game ends. We run out. Goodwill dissipates. And we have to start paying for our standard of living from cash we earn rather than cash we borrow.

Maybe the fall of the dollar signals that we have reached that end.

If so good.

Meanwhile we need to manage the dollar’s decline carefully. Too precipitous and we will have to drive up interest rates so we can keep borrowing enough to pay our bills. That would nip the recovery in the bud.

A lingering and slow decline is more desirable. That would buy us time to start saving enough of our own money so that we don’t need to keep on borrowing abroad.

Nothing’s easy in currency trading. That’s why predicting the dollars value with any notion of precision is a fool’s game. It is a game of trends and not exact values.

So: look for the dollar to fall some more. In general I would expect it to be lower next year than this. But be careful: some of those foreign economies are worse than ours so their currencies will fall faster.

Caveat emptor.