Is the Dollar Too Weak?

Economists readily agree that on the domestic front, low inflation, low unemployment and high growth are always good for the economy. When it comes to international goals however, whether a country should have a stronger currency or a weaker currency is often open to debate. This is reflected in the changing position of the United States.

The U.S. has long had a “strong dollar” policy, but in recent months it seems to have pursued a policy of weakening the dollar. The main topic of discussion in February among the financial representatives of seven major national economies (the group of seven, or G-7) was the declining dollar. Comments made by U.S. Treasury Secretary John Snow were perceived to mean that the administration welcomed the decline, especially against the euro.

Then in April, U.S. Vice President Dick Cheney was in China (not a G-7 member) pressuring the Chinese leadership to float its currency, the yuan, which would increase its value against the dollar (most economists agree that the yuan is undervalued relative to the dollar).

So why is the U.S. government trying to weaken the dollar? And is that a short-sighted policy?

“[T]he Bush administration has made a calculated economic and political choice. By condoning and even encouraging a cheap dollar, the administration is providing a big push to American exporters by making their products less expensive in foreign markets. That should encourage more hiring and lower unemployment leading up to the election” (New York Times, February 9).

Advantages and Disadvantages

The main advantage of a weaker dollar is that it makes foreign currencies more expensive, thereby making imports into the U.S. more expensive and exports from the U.S. cheaper. By encouraging exports and discouraging imports, the administration not only hopes to stimulate manufacturing jobs but also to shrink the trade deficit.

But there is a price to pay for a weaker dollar.

Higher import prices mean that American consumers will pay more for a lot of their electronics, much of their clothing, many of their cars and much of their oil. As import prices rise, domestic producers will likely increase their prices as well, leading to inflation.

Furthermore, America depends significantly on foreign investment to finance its budget deficits, and an unstable dollar becomes a riskier investment. Higher interest rates may be required to attract that needed capital. If that happens, the interest payments will add billions of dollars to the budget deficit. When higher interest rates are paid on investments, it can push other interest rates up too.

Consequently, not only do consumers face the prospect of higher prices (on imports, at a minimum), but those who hold variable-rate debt could be burdened with higher interest payments as well.

The U.S. government is willing to take all these risks by promoting a weaker dollar in order to lower the trade deficit and reduce unemployment. Why? To discern properly, we first need to understand what causes the value of the dollar to fluctuate.

Exchange Rate

People exchange currencies to buy goods, services or assets in other countries. The exchange rate is the rate at which one country’s currency can be traded for another country’s currency. It tells you what the price of a foreign currency is. Exchange rates are determined by supply and demand.

Say, for example, a European wants to buy an ibm computer made in the U.S. He has euros, but ibm wants dollars. In order to buy the computer, he must exchange euros for dollars. In this case, the demand for dollars comes from a European who is willing to give up euros in order to buy an American product.

To facilitate these kinds of transactions, the buying and selling of currencies takes place in the forex (foreign exchange) market. Commercial banks and other financial institutions, corporations or even individuals may buy and sell money—using one currency to purchase another. In essence, the forex market is governed by the law of supply and demand. The price set for each country’s currency is determined by the desire of those trading to acquire more of it or to hold less of it.

As we saw with the example of the European wanting to buy an American computer, this supply-and-demand framework for currency ties in directly to the supply and demand of a country’s goods, services and assets. It boils down to this: Barring government intervention, if country A sells more to country B than it purchases from country B, country A’s currency is in demand more than country B’s (relative to each other). This will tend to push up the value of country A’s currency relative to country B.

If country A purchases more from country B than it sells to country B, country A’s currency is in demand less than country B’s. This will tend to push down the value of country A’s currency relative to country B.

When a country allows market forces to determine the value of its currency, it is said to “float” the currency.

Governments, however, sometimes intervene in the forex market in order to maintain a desired exchange rate. For example, for about a decade now China has fixed its exchange rate by “pegging” its yuan to the U.S. dollar. As the value of the dollar fluctuates, so does the yuan. How is this done and why?

China had a trade surplus with the U.S. of $124 billion last year. The exchange rate is about 8 yuan to the dollar. Barring asset sales, China’s trade surplus of goods and services shows that the yuan is more in demand than the dollar—more Americans are buying Chinese goods and services than Chinese are buying American goods and services. In essence, at the price of 8 yuan to the dollar, more people want to buy than sell yuan. This pushes the price of the yuan up, because there is a greater demand for yuan than people are willing to supply (or sell).

In order to compensate for this upward pressure on the yuan and to prevent it from rising in value against the dollar—to keep it at 8 yuan to the dollar—the Chinese central bank simply sells yuan in the forex market. It sells enough to satisfy the excess demand to the extent needed to bring the price back down to 8 yuan to the dollar.

The main reason China pegs its currency to the dollar is to keep the price of its exports relatively stable and cheap for the American consumer. The Chinese economy relies heavily on its exports.

As we examine more closely the question of whether the dollar is too weak, keep in mind that supply and demand causes the exchange rate to fluctuate.

The Impact of the Trade Deficit

While there are several factors that have caused the dollar to fall, “The biggest single factor … has been the soaring deficit in U.S. trade. The United States imports [demands] far more than it exports [supplies] in goods and services. U.S. consumers have a strong appetite for Japanese automobiles, Chinese clothing, German machinery and Finnish mobile phones. Oil imports, by far the largest item, grow steadily. U.S. companies are not able to export products and services of the same value” (Global Policy Forum, August 2003).

Between 1990 and 2000, U.S. exports doubled, but they’ve been relatively flat since then. America exported a little less last year than in 2000. Meanwhile, imports continue to climb to the extent that America’s trade deficit (the difference between imports and exports) was a whopping $489 billion in 2003—an all-time record.

Basically, the trade deficit means that as a country, the U.S. consumes (or demands) more than it produces (or supplies). This “excess consumption” has to be financed! The trade deficit is paid for by selling U.S. assets—physical assets such as factories, land and buildings, or financial assets such as U.S. dollars, stocks and bonds. In other words, for every $1 of deficit goods and services consumed, the U.S. must sell $1 of its assets.

“Foreign central banks, led by China’s and Japan’s, now hold close to $1 trillion of Treasury bonds and bills, almost a quarter of publicly held U.S. debt” (Wall Street Journal, April 26). And many of America’s largest corporations, such as Amoco, Chrysler and portions of Lucent and ibm, have been gobbled up by foreigners.

Furthermore, “Large parts of Wall Street have also come under foreign control. Names like Scudder Investments, Bankers Trust, First Boston, Alliance Capital, Republic Bank, Kemper Corporation … may still sound American, but these former pillars of the U.S. financial establishment are now controlled from places like Zurich, Frankfurt, Paris and London. Even the American book-publishing industry is now largely foreign-owned. According to one estimate, German companies alone now account for more than half the industry. American publishers that are now German-owned include Random House; St. Martin’s Press; Doubleday; Crown; and Farrar, Straus & Giroux” (American Prospect, March 2004).

“In effect, the United States is selling the family silver. Within the space of a single generation, it is disposing of much of its industrial and commercial base—a base that was built by many earlier generations of Americans” (ibid.). In 2002 alone, foreign-owned assets in the U.S. increased by $707 billion while U.S.-owned assets abroad increased by only $179 billion. This is a negative investment-asset difference of $528 billion! (Figures for 2003 are not available as of this writing.)

It should be obvious that sooner or later America needs to start producing more than it consumes—not only to preserve ownership of remaining assets, but also to stem the flow of dividends and interest payments that the U.S. must remit to foreign owners of U.S. assets.

The trade deficit is a very serious problem, and though it doesn’t get as much “press” as the budget deficit, we can begin to see why Washington is concerned and why it is promoting a weaker dollar to try to encourage more exports. But is that a good solution?

Barriers to More Exports

In theory, a weaker dollar should stimulate exports, reduce the trade deficit and increase jobs. But this assumes that there’s enough unused manufacturing capacity to turn things around. “After 30 years of rising merchandise trade deficits, much of America’s once formidable manufacturing capacity has been wiped out” (ibid.).

Also, many U.S. manufacturing companies have relocated some or all of their operations abroad. They produce around the world and sell to foreign markets as well as to the U.S. from locations outside America. “The best estimates are that around 45 percent of all U.S. imports are intra-trade within U.S. companies that produce outside the U.S. and sell inside the U.S.” (Le Monde Diplomatique, October 2003; emphasis mine throughout). That is not likely to change.

Furthermore, countries like Japan and Germany “now increasingly specialize in producing goods that Americans can no longer make (or in some cases never have made), including advanced materials (such as super-strong composites used in planes), key components (such as the more advanced components in cell phones) and sophisticated capital goods (everything from the semiconductor industry’s ‘steppers’ to television broadcasting equipment)” (American Prospect, op. cit.).

And some of what the U.S. exports is imported content that is then re-exported as part of something else. “Virtually every American-manufactured product these days is heavily dependent on imported content. Indeed, America’s most advanced manufacturers have led the trend to outsource the most-difficult to make components and materials from former rivals in Japan and Germany. A classic in this regard is Boeing, which is relying on Japanese partners for much of the serious manufacturing in its forthcoming 7e7 jet” (ibid.).

This also occurs when, for example, goods that Asian manufacturers air freight to Los Angeles are then trucked to Mexico. At the border they are recorded as U.S. exports to Mexico.

Finally, while a falling dollar may indeed have some impact in lowering export prices, it does not make exports cheaper to countries like China that peg their currency to the dollar; and the effect is mitigated in countries that have unfair trade practices or that might impose trade barriers.

In spite of these impediments, we can still expect the weaker dollar to add impetus to exports overall, but most likely not to the degree needed to overcome the trade deficit. It should be obvious that more far-reaching solutions are needed to fix the structural problems that underlie the cause of the trade deficit—not only in physical capital shortages but also in human and social capital deficiencies.

Even with the benefits that accrue from cheaper exports in the short run, a weakened U.S. dollar is a dangerous policy to embrace.

The Implications of a Weakened Dollar

Remember that two likely side effects of the sliding dollar for the U.S. are higher interest rates and climbing prices, especially on imports—not the least of which is oil. The Middle East oil-producing countries sell oil in dollars, but they import much of their goods and services from the European Union and must pay for them in euros. As the dollar loses ground against the euro, their purchasing power deteriorates. They can either raise prices (as Americans have already experienced at the gas pumps) or start pricing oil contracts in euros as Iraq did in 1999.

Russia also sells oil in dollars but imports many of its goods from the EU. So it is losing purchasing power too. According to www.gateway2russia.com, the deputy chairman of the Russian Central Bank has recently suggested abandoning the policy of pegging the Russian ruble to the dollar only, replacing it with both the dollar and the euro (March 1).

The unstable dollar is putting pressure on central banks around the world to move away from dollar reserves. In fact, several have already reduced their dollar reserves to stop further losses. “A new analysis by Lehman Brothers estimates that in the last half of last year as much as $133 billion of foreign exchange reserves in non-Japan Asia left the dollar for stronger, higher-yielding currencies such as the euro” (Observer, February 22).

What this indicates is that the U.S. dollar—as a result of its weakening—is losing some of its status as a reserve currency. This has far-reaching implications. In order to be able to transact business on a global scale in a smooth manner that promotes growth, the world relies on a universally accepted currency—the reserve currency. In the 19th century, the British pound sterling served the purpose. After World War ii, the U.S. dollar gradually replaced it.

“A national currency becomes an international reserve currency for other countries when it is established as the currency of choice in global finance and trade, owing to its overwhelming relative economic and financial power. Countries are eager to hold that currency as a reserve. It is a cherished asset that can be deployed anywhere, in any nation with which it has international economic relations, because it knows that every other country also wants this currency as a reserve for the same reasons it desires the currency” (Le Monde Diplomatique, op. cit.).

The U.S. has a big advantage for this reason. It is the only nation that can simply print dollars and easily exchange them for other currencies to buy products without increasing the domestic money supply and risking inflation. It’s like getting an interest-free loan, and it is one reason the U.S. economy has been able to run trade deficits.

The real danger of a weakening dollar is that it cools the demand for dollars as a reserve currency! If the dollar continues to fall over time (which some analysts say it must), and if demand wanes and the supply of foreign capital starts to dry up, we face the prospect of strategic power shifts in global markets that would weaken the power of the U.S.—the same thing that happened to Britain not so long ago.

The Euro Challenge

In 2002, 12 nations of the EU adopted the euro as their common currency. It was not just for domestic economic reasons. “[P]lanners hoped that the importance of the euro would lead individuals throughout the world to hold their assets in euros rather than in dollars” (David C. Colander, Economics). Recent U.S. aggressiveness, as Europe sees it, and the meteoric rise of the euro against the dollar have rekindled that aspiration. There is renewed speculation about whether the euro can become an alternative reserve currency to the dollar.

Admittedly, there are structural problems that hinder such a development. For example, the practices of the European banking system are cumbersome in handling transactions between countries compared to U.S. banking practices. And there are policy roadblocks such as the stability and growth pact that the European Central Bank interprets very narrowly and that unduly constrains national fiscal policy, especially in the economies of Germany and France.

While there are reasons to doubt the emergence of the euro as a reserve currency, remember that the U.S. dollar also has three enormous vulnerabilities: persistent trade deficits now running at about a half trillion dollars a year, budget deficits that are perceived to be out of control, and a lack of confidence in Washington’s foreign policy decisions (whether justified or not).

Meanwhile, the weaker dollar is indeed hurting European exports to the U.S. and undercutting the growth of the EU economy. This is placing “unexpected and growing pressures on the euro zone governments to advance structural reforms to make their economies more competitive” (Stratfor Global Market Brief, February 16). If the EU advances these reforms faster than the U.S. can put its financial house in order, watch for the euro to increasingly edge out the dollar as a preferred reserve currency. This would especially occur if more terrorist attacks on U.S. soil further undermined confidence in the U.S. dollar as a safe haven.

“Britain’s 200 years of global supremacy were based on a strong currency, a large trade surplus and growing foreign investments. Trade decline in the late 19th and early 20th century gave a clear sign that Britain’s empire was on the wane. Today’s trade and payments deficits, and the falling dollar, may point in the very same direction for the global order based on U.S. dominance” (Global Policy Forum, op. cit.).

Bible prophecy shows this is a correct analysis. Speaking through Moses to the ancestors of modern Britain and America, God promised, “He will lend to you, but you will not lend to him. He will be the head, but you will be the tail. All these curses will come upon you. They will pursue you and overtake you until you are destroyed, because you did not obey the Lord your God and observe the commands and decrees he gave you” (Deuteronomy 28:44-45; New International Version).

Because the people of America are increasingly profaning God’s commandments, God will follow through on His promise. Just as Great Britain and its pound sterling were toppled from economic supremacy, so will the United States and its dollar be toppled. Look for the dollar to decline in value further over the long haul, and keep your eye on the European currency as it rises to prominence along with a united Europe.