Thursday, October 8, 2009

Down goes the dollar -- at last

In this July 22, 2009 column, I wrote: "There is no doubt the price of goods and services we import has to rise; and the costs of our exports needs to fall. That means a much weaker dollar in the coming years."

Two and a half months have passed since I forecast the dollar's decline. This week, the fall began. Here is today's story in Forbes:

The dollar fell to a 14-month low against a basket of currencies, as positive news about the global recovery enticed speculators to test how much they can pressure the greenback.

Currency traders have their eye on the dollar's technical borderlines, anxiously waiting to see if the euro will punch through $1.485, and if the yen can fall to 87.50. It's getting close, as the euro rose to $1.481 Thursday, while the yen fell to 88.31.

The Dollar Index, which measures the greenback against a number of other currencies, fell by .8%, to 78.81. Yet, in the intensity of inter-day trading and the heated geopolitical and economic climate, it's easy to forget the dollar is sliding to its pre-crisis levels. Prior to July of 2008 the euro was on a multi-year march to $1.599, while the Australian dollar reached 97.93 cents.

For the United States, the short-run implication of a declining dollar should mean higher interest rates on our public debt. Why? Because foreign investors own much of our massive debt. They won't want to purchase our treasury notes if those notes are paying a negative real interest rate. And if the dollar is declining in value -- say by 5 percent -- and the notes are paying 4 percent in interest -- then the real interest rate is negative.

The major players in this will be the central banks in China, Japan and Russia, as well as major dollar investors from OPEC. China holds $800.5 billion in American government debt. Japan owns $724.5 billion in U.S. treasuries. And Russia, which has sold off some of its U.S. government bonds, still possesses $118.0 billion worth.

To me, the surprise is not that the dollar is falling. The surprise was that when the world economic crisis hit in 2008, largely a byproduct of the collapse of mortgage backed securities originated in the Unites States, that the dollar rose. It was seen as a flight to security. However, given our immense red ink, I don't see the dollar as a safe investment.
The move out of the dollar is understandable. The macro picture is improving, and the turmoil over the past year led investors to flock to the dollar as a safe-haven play.

Volatility in equities, commodities and fixed income markets have served to mask the dollar's weakness but now all that's propping up the dollar is the world's willingness to keep investing in it. China and other surplus producing countries (particularly in the middle east) stand to lose trillions should the dollar fall too far too fast. Exporting nations would also benefit from a stronger greenback though there's some evidence that the traditional exporting role of the emerging markets is being tested.

Before the crisis hit in 2008, our massive public debt plus our ever-increasing trade deficit suggested to me that the dollar had to fall. However, since the crisis, every policy pursued by the U.S. government has served to make the dollar much weaker. We have a much more severe federal debt, today, in the wake of Bush's bail out program, Obama's bail out and the stimulus package. The erosion of fiscal discipline in the United States will mean two related things in the future: consumer price inflation and a much weaker dollar.
The dollar is inherently weaker than it was before the crisis, as the Federal Reserve has lowered interest rates to bottom-barrel levels, while the U.S. Treasury has taken on significant debt in an effort to save the financial system from collapse, as well as revive the economy. On Thursday the Congressional Budget Office reported the federal budget deficit reached a record $1.4 trillion, due to a drop in tax revenue, as well as the government's massive bailouts.

The weaker dollar will bring about big changes for the U.S. All commodities will cost American consumers a lot more money: food will be much more expensive; gasoline will sour in price; and things like foreign travel will become cost prohibitive. On the other hand, goods and services which we export will be cheaper to foreign buyers. We will export more cars, appliances, agriculture and raw materials. It will make more sense for films and TV shows to be produced in the U.S. in the years ahead than it does now.

A weak dollar by definition means a much lower standard of living. It would not surprise me to find 20 years from now that the median standard of living in the United States in 2020 is lower than it was in 2000.

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