Monday, September 10, 2007

The dollar's dangerous decline

In posts here the decline in the value of the U.S. dollar has been frequently mentioned as an issue of concern. Over the last five years the dollar has declined in value against a basket of foreign currencies by more than 30%, and by quite a bit more than that against the Euro and the Pound. For every ten commentaries by politicians and the media about either interest rates or stocks there may be, at best, one about this issue. It's a bigger issue than that suggests. Here's the deal.

It is not news that our economy is global. More than half of the total U.S. treasury issues afloat are held by foreign investors. Imports fill our car lots, our clothing stores, toy stores, electronics stores, Wal-Marts, Targets, even appliance stores and on and on. They also fill at least half of our gas tanks. Eventually a dollar decline will not be a good thing.

When the dollar loses value, purchasing power goes down. We don't see it yet, for the most part, because many imports are produced at cheaper costs and as the import substitution has grown and grown it has not been inflationary even with the weaker dollar. At some point in time this import substitution benefit will end, and with a continued decline in the dollar many products will eventually cost more. It will happen first in more sophisticated goods like cars from highly developed countries(and this will finally give U.S. automakers who have been slimming down by necessity a chance to raise their prices) and will spread down the value chain of products. The congressional pressure on China to revalue the yuan could accelerate the pressure, and there will be that "tipping point" at which the U.S. consumers will feel the pressure of higher prices in a meaningful and maybe painful way. Instead of waiting for this eventuality they could just go spend a week in Europe and see what it's like.

The counterargument to this is that a weaker dollar strengthens U.S. export industries, and therefore creates jobs and wealth. This is absolutely true and it has in recent years been a huge benefit to many major companies and to the aggregate economic statistics. Two issues though, at least two. Much of the benefit is in the translation of foreign currencies back into U.S. dollars rather than a surge in good job growth and more importantly wages and benefits in the U.S. And, much of the wealth created will be for the professional and investor class, which does not include the majority of U.S. consumers. "Trickle down" is not a term without meaning but if that "tipping point" arrives, a trickle will not likely do the trick.

Then there's the question of interest rates. The Fed will likely need to cut interest rates in the near future to stabilize financial markets, help borrowers and guard against a slowing economy. The irony is that an interest rate cut could lead to higher interest rates. How's that again? An interest rate cut will put pressure on the dollar. With foreign investors holding so much U.S. debt, they will not stand by idly watching their return diminish when their maturing bonds translate back into fewer pounds, yen, euros, dinars, or yuan. They will demand a higher interest rate to compensate. So a rate cut would lower short term interest rates and initially lower rates across the yield curve. In this crisis style market a flight to quality, meaning to the major currencies, could delay an impact, but in the near future it is likely that medium term and longer term interest rates would increase, and increase to levels above those before the cut.

Inflation in prices, inflation in interest costs, what else? Maybe inflation in words about the dollar's decline as this post might suggest. At some point doesn't this become an important national issue, a dent in reputation and a sign of weakness in the global economy. Or does it just mean that some Americans will get to play on another level at a global pricing structure while the great majority goes to the table with a beggared currency.

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