Playing on the movie title, “Honey, I shrunk the kids,” Americans today might well say, “Honey, they shrunk the dollar.” The physical size is still the same, of course, but the value has diminished, especially when compared to some of the world’s other leading currencies, particularly the euro, the dollar’s main competitor for the attention of the world these days.
For most of the 20th century, the American dollar was “king of the hill” and, in fact, the US was the only major country that was economically stronger at the end of World War II than at the beginning. The US dollar became the standard by which everything else was measured. Until the early 1970s, most exchange rates were pegged to the dollar and any reduction in a currency’s value relative to others was known as a “devaluation” and could be an enormous blow to national pride. Today, currency prices change second-by-second, resulting in more focus on market trends.
Other things have changed over the past generation as well. While the US is still a military super power, it is no longer the only key economic power. The downward trend of the dollar’s value is not news to economists or Wall Street, but it is often a shock to the average American, especially for those who venture outside our borders. In many parts of the world, a dollar buys less than it did this time last year and much less than four years ago.
In November 2005, the exchange rate for one euro was $1.17; today, it is around $1.44. This rate is discouraging Americans to travel to Europe because of the rising costs. The loss in the value of the dollar is not all negative, however, as it is encouraging more Europeans to journey to the US where they can purchase American services and products.
The shrinking value of the dollar also benefits US manufacturers because trading partners are more willing to buy greater amounts of American products. In other words, a weak dollar does not necessarily mean a weak economy. Such a situation encourages US exports and helps narrow our trade imbalance.
On the flip side, however, products from the 13 nations whose currency is the euro are costing US consumers a bit more which, in turn, forces the Federal Reserve to work smarter to maintain stable prices while at the same time attempting to promote economic growth. Situations like the recent mortgage debacle can really complicate matters.
The US has been running huge budget and trade deficits for some time. As a result, we are heavily dependent on foreign investment in US Treasury bonds to cover the deficit. Last year, our nation had to attract about $3 billion every working day in order to bridge its deficits, which were about 6.5% of the gross domestic product.
The drop in the value of the dollar has the potential to create less demand for US Treasury bonds, the result of which could cause a rise in long-term interest rates. In such a case, borrowing costs would increase for our government and probably result in higher mortgage payments for many American homeowners. Although it is highly unlikely, if foreign businesses sense a significant rout of the dollar, they could decrease their purchases of US bonds or dump their holdings and thereby cause a significant crisis. Because we remain the world’s model for political stability in very uncertain times, the odds of that happening are about the same as those of the Cubs winning the next ten World Series.
As Americans, we spend way more than we save, and we love to shop. This inclination to live beyond our means has exacerbated the nation’s borrowing binge over the past 20 years or so. The Bush administration, like its predecessors, believes the strength of the dollar is highly important to the ongoing growth of the economy, but they differ in believing that the marketplace should determine the worth of the currency. The lessening of the value of the dollar is the market’s way of trying to stem the tide and slow borrowing trends. As noted above, it is also somewhat self correcting in that it tends to encourage exports and discourage imports.
The responses we make to these market stimuli could well determine just how far the dollar is going to shrink. Moreover, our actions will help define whether the weaker dollar is good news or bad news in the long run.