During the course of an average year, I give hundreds of speeches to groups of all types. I always try to interject a little humor as not all of you share my fascination with the arcane world of economics and statistics. One joke always gets a laugh, a sure indication of the underlying kernel of truth. In essence, it goes like this: if you laid all of the economists in the world end to end, they’d still point in every direction. In other words, agreement is a rare thing indeed.
The current situation with regard to the weakening dollar is no different. However, the range of opinions is perhaps outstanding even for my chosen profession. On the one hand are those who spout forth gloom and doom over a coming crisis that will shake the foundations of the US economy, tank the stock market, and cause interest rates to soar. Others describe the same situation as one that will benefit the US economy by making our exports more affordable and moving the dollar closer to a value compared to other currencies that is sustainable in the long term. The majority of us, myself included, fall somewhere in the middle. First, a few facts.
The dollar has fallen against the currencies of our trading partners over the past few years, down some 15% since 2002. Why the drop? Currencies trade in markets, and prices are largely driven by the supply and demand for dollars. The supply rises when the US runs a large budget deficit, as has been the case since 2002 (largely due to the war on terror). Currently, deficit spending is causing the US to dump another $1.5 billion on the market every week in the form of dollar-denominated treasury securities sold on the open market. If, as a group, US consumers and companies are spending more than they are saving, foreign investors and central banks take up the slack, buying corporate bonds and other securities. In times of political unrest, dollar-denominated securities become more attractive because the US involves the least political risk of any country on the globe.
The delicate balance of supply and demand of dollars sets the exchange rate, which is the dollar’s value in terms of other currencies. Foreign trade is affected by (and, in turn, affects) exchange rates. As the dollar becomes weaker, US goods are more affordable to foreign consumers—it takes fewer yen, marks, or yuan to purchase the same US computer, television, or other good than when the dollar is stronger. At the same time, imported goods (and international travel) become more expensive for Americans. This is generally a good situation for the US, with rising exports generating economic activity.
However, problems arise if the dollar falls too far too fast. Weakening currencies hold little appeal for foreign investors; a position in a dollar-denominated treasury bond loses value as the dollar weakens. To compensate, interest rates would have to rise. Everything from the housing market to business investment to consumer goods companies to the rest of the economy would suffer. But the worst-case scenario assumes dollar demand falls precipitously, and, frankly, that’s unlikely. The US remains one of the safest places to invest, and confidence in the stability and security of the US economy is high.
Another, perhaps more ominous, aspect of currency markets is that they are not totally driven by economics. There is some buying of dollars that is politically motivated. For example, China now holds hundreds of billions of dollars and dollar-denominated securities. By threatening to stop buying or (even worse) begin selling, China could conceivably cause the dollar to slide further against world currencies. Given that Beijing is not too happy about the mega-deal for the US to sell weapons to Taiwan, the motivation to wreak havoc in our economy could be there. However, the sheer size of China’s holdings makes such a course of action unlikely in that the loss in value of those investments would take a toll on the Chinese economy. If they threaten the dollar, they also lose. This fact is also magnified by the large quantities of Chinese goods purchased by US consumers and businesses.
At the end of the day, that may be what keeps a major crisis from ever occurring. The world’s economies are so intertwined that a slowdown in the US is bad for virtually everyone. While it may take market intervention by some group of countries at some point in the future to stabilize the dollar and restore historical parity, the motivation to do so will be very strong.
All in all, it’s generally a good thing for the dollar to decline in times when we are sporting record trade deficits. It helps maintain a healthy balance and stimulates purchases of US goods and services. If it were just economic forces at work, I would be firmly in the camp of those economists who view the current situation as a positive development for the US. The political games that could be played, however, present something of a concern, but nothing to lose sleep over at this point.