Why Is The Dollar Falling?
Much has been made of the falling U.S. dollar, especially against the euro, British pound, and Canadian dollar. Why is this happening and what can we do about it? There are a few fundamental reasons for the dollar’s demise and a few (painful) remedies.
I must start by pointing out that fiat currencies, such as the U.S. dollar, are actually designed to lose value over time. Our economic and financial systems are structured in such a way that moderate rates of inflation are required for healthy economic growth and to maintain stability. Thus, it is incorrect to say the euro or pound have gained in value over the past few years simply because they buy more dollars than they used to. It is more correct to say the euro, pound, and other fiat currencies have simply lost value less quickly.
Loose Monetary Policy
One of the primary culprits of the falling dollar is low interest rates. The Federal Reserve, in an attempt to avoid a serious recession after the tech bust, appears to have over-compensated by lowering interest rates too far and keeping them there too long. This, of course, led directly to the subsequent real estate boom and current subprime crisis. Credit was too cheap for too long and when money is cheap, people tend to over-indulge. After all, when your after-tax rate is at or below the rate of inflation, you’re effectively getting free money. It’s hard to fault most people and firms for backing up the truck. This leads to inflation.
But lower interest rates contribute to a lower dollar in a much more direct way, as well: it reduces the attractiveness of dollar-denominated cash-equivalents to foreigners. If you’re a foreigner, where would you choose to invest your money…in a dollar-denominated Treasury note paying 3% or some other government bond paying 5%? All else being equal (i.e. comparable credit-worthiness etc), you’d choose the 5% bond every time. To compensate for this rate discrepency, the value of the dollar has to fall relative to competing currencies in order to attract investors. It’s a market, after all.
The solution to this problem is obvious: raise interest rates. Well, it’s not quite that simple. Raising rates would set off a chain reaction, leading to reduced liquidity (probably a few more failing banks) and an accompanying recession. Nobody wants a recession, but we may not have a choice. The longer we prolong the pain, the worse it will be. Better to cleanse the system with a quick albeit severe recession, like pulling off a band-aid, than a slow, gruesome death spiral. We are heading towards the slow, gruesome death spiral. Unfortunately, voters don’t like being told the truth, so action is always pushed back “until later.”
Buy American
The other major cause of the dollar’s demise is America’s huge trade deficit. Basically, we buy more from the rest of the world than we sell to it, resulting in a transfer of dollars from Americans to foreigners. And what happens when the supply of any good (dollars included) increases relative to demand? Its price goes down. This problem is actually self-correcting, however, because as the value of the dollar plunges, imports become increasingly more expensive relative to domestic alternatives, incentising people to buy American. Similarly, American exports because less expensive on foreign markets, inducing foreigners to buy more American products. Not surprisingly, export-oriented firms are booming right now. However, I don’t foresee the dollar having a full recovery until the Fed tightens monetary policy and regulates credit markets more effectively. I’m not holding my breath in an election year, though.
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Since individual investors cannot directly effect change in dollar value, the fall back position has to be allocating some invested assets to capture benefits from relative movements in foreign currency valuations, e.g., non-hedged foreign treasury bond funds. Do you agree?
Agreed, although you could use non-hedged foreign stock funds as well. I personally just use foreign stocks and not bonds. If I had a much larger portfolio, I would probably diversify a little into foreign bonds.
It’s not necessarily “buy American” that’s the solution to the US trade deficit. What should ideally be happening is that the US produces more and exports more to other countries.
Protectionist and isolationist economic measures just can’t work anymore in the global economy.
I always get irked when I see those bumper stickers that say “Out of a job yet? Keep Buying Foreign!”
It shows ignorance, because every product and service (not to mention innovation, skill and manpower) we all use today is a mix of “domestic” and “foreign.” I saw the sticker yesterday on a GM truck (in Canada) that was made in the U.S. How ironic for that driver!
However, in the end what is essential if the greenback isn’t to truly collapse is that the US pays off its massive debts. It seems that the Fed is trying to inflate its way out of paying off its debts.
I think the important thing is that it is indeed falling against the Canadian dollar which makes trips to the US cheaper for me!
Congrats on the new network – I think you will benefit from it.
Mike
Hi Kyle,
I really enjoyed reading this post and agree with upping the interest rates and allowing the system to cleanse itself out. It seems ridiculous to keep prolonging the inevitable and making the outcome even worse.
I’m sure the economic stimulus checks served their purpose in forcing the recession into 2009. Unless, of course, there’s a new batch coming our way through the pipelines in time for the holidays.
There is another reason for this problem – other countries artificially keeping their currencies low against the US dollar. Japan has done this since WWII (and built a world class economy on it) and China is doing it today. By keeping their currencies artificially low compared to the US dollar, their products are cheaper in the US. This has resulted in the mass exodus of manufacturing jobs out of the US. Granted, some of this would happen on a smaller scale no matter what, due to cheaper labor rates, but why is it the US dollar has fallen 10% against the Chinese currency vs. almost 100% vs. the Euro? Because it keeps Chinese products cheap here. Had the same market forces that affected the dollar to euro exchange allowed to affect the Chinese currency to dollar exchange, Chinese made goods would be almost twice as expensive here now. Markets would correct, more goods would be made here and less would be bought from China. China would be sharing in this recession instead of leeching off of the US as their economy storms ahead at double digit rates and companies would not be shipping mass numbers of jobs to China. (I see it, literally, every day in my job.) So much for the Invisible Hand when governments intervene to turn that Hand aside and when our government doesn’t have the initiative or the political courage to do something about it…
Monetary policy