The Buck Drops Here

After several years of reigning supreme, the U.S. dollar has dramatically tumbled in value over recent months. The slide is particularly pronounced when measured against the euro—falling 11 percent in the first five months of this year, making a total decline of 24 percent since the start of 2002.

Gone are the days of the investment boom of the 1990s, when investors poured billions of dollars into the U.S., chasing gains from the tremendous surge in value of the stock market and thus supporting a strong dollar. That money made it cheaper and more profitable for companies to invest, in research and development, in machinery, in improved technology. This investment boosted productivity (output per hour worked), and U.S. economic growth generally outpaced that of the rest of the world.

American, as well as foreign, investors jumped on the bandwagon. No longer was the stock market the exclusive playground of institutional investors. Stocks became the investment of choice for thousands of U.S. households wanting to share in the spoils.

As the value of U.S. stocks surged during the 1990s (the Dow Jones industrial average more than tripled in that decade), so did the net worth of U.S. households. As an individual’s ratio of net worth to disposable income increases, so does his inclination to spend. No longer does he see the need to save for a “rainy day” because he now has an abundance of financial assets at his disposal should that “rain” ever materialize.

Consequently, the dramatic increase in wealth led to a spending spree in the U.S. that has continued ever since.

Financial Markets Unravel

But as the world ushered in the new millennium, the financial markets began to unravel. Stocks had hit their peak. Technology firms led the way on the slippery descent, pulling the rest of the market behind them. Many of the once-famous dotcoms, formerly the pride and joy of the equity market, failed—and billions of dollars of wealth suddenly vanished.

Remarkably, however, consumer spending continued to surge! This was due in part to the unprecedented availability of credit. The personal savings rate plummeted to new lows, and in 1997 America’s private sector became a net spender, reversing a 40-year history of annual savings averaging 2.6 percent of gross domestic product (gdp). No amount of spending seemed to satisfy the newfound appetite of the American consumer.

Consumer spending makes up two thirds of the United States’ gdp. It is this consumer spending that has continued to prop up much of the world, to the point where many economies have now become dangerously dependent on this over-indulgent beast (see “The Burden of John Q. Consumer” in our June issue).

The relative strength of the U.S. dollar fit well with consumer tastes. Foreign goods were now cheaper for U.S. consumers, and imports poured in quickly to satisfy voracious consumer appetites. The result was a recurring current account deficit, which continues to widen today.

As the wheels of industry began to slow, the Federal Reserve cut interest rates in an attempt to keep this great beast feeding. The rate reductions allowed easier access to capital gains through home equity loans, and also made it more cost effective for business to invest in capital.

However, as a result of the evaporation of wealth, recent business scandals (such as the Enron and WorldCom debacles) and the war in Iraq, business confidence waned, unemployment grew, and growth slowed.

America is no longer the attractive, high-yielding investment paradise it once was.

Despite the recent movement by the European Central Bank to cut interest rates, the benchmark lending rate is still significantly higher in Europe than it is in the U.S. (2 percent compared with 1.25 percent), giving euro-based assets the advantage over dollar-based assets. The upshot is a flow of funds from the dollar to the euro and hence a reduction in the dollar’s value.

Short-Term Benefits to U.S.

So far, the depreciation of the dollar has benefitted the U.S., for several reasons.

The weaker dollar improves the competitiveness of U.S. exporters. U.S. goods are cheaper for its trading partners to buy, giving exporters more pricing power and stimulating demand. This is a welcome development at a time when U.S. manufacturers are struggling.

So great is the advantage of a depreciation to exporters that, in an effort to protect its own export sector, Japan has bought a mass of U.S. dollars—an incredible $56 billion this year—to curb the dollar’s downward slide (and the corresponding appreciation of its own currency). Even with such substantial intervention, Japan has not been able to totally insulate itself from a slide in the dollar.

With an increase in the price of imports, domestic demand in the U.S. is also stimulated as consumers buy American-made products instead of foreign products.

It appears that the U.S. Treasury is relaxing its traditional commitment to a strong dollar in an effort to kickstart an export-led recovery. It is hoped that the combined effect of increased exports and decreased imports will finally turn the tide on what has been an exploding current account deficit in recent years.

Short-Term Effects in Europe

The sliding U.S. dollar is a huge threat to Europe in the short term. The record rise of the euro has sparked fears that it could push eurozone countries into a deflationary spiral.

In the same way that the weaker dollar aides U.S. exporters, a strong euro inhibits European exporters. It makes their goods more expensive and hence less competitive.

The implications of a sliding dollar (and a strengthening euro) for Europe go far beyond affecting only trade with the United States. Because of the immense size of the U.S. economy and the liberal spending habits of its consumers, many of Europe’s trading partners have become dependent on the U.S. to fuel their own economies. They therefore have a vested interest in ensuring the U.S. dollar does not depreciate against their own currency, thus hurting their export industries.

These nations achieve stability and reduce exchange-rate risk in one of two ways. Either they intervene in currency markets to prevent the slide of the dollar (such as Japan did, buying $56 billion) or they peg their currency to the U.S. dollar (as is the case with China, most Arab countries and some South American countries). A reduction in the value of the dollar translates into an automatic reduction in the value of the pegged currencies. The upshot is, European exporters are not only less competitive against U.S. firms, but also against much of the rest of the world.

This situation could have serious implications for European economies—especially Germany, Europe’s largest. Germany is already in recession (a decline in real gdp for two consecutive quarters). It has proportionately a larger manufacturing sector than other advanced economies, which is especially sensitive to exchange-rate movements.

Unemployment has exceeded 10 percent, and the budget deficit has surpassed the 3 percent limit allowed by the European Union’s Stability and Growth Pact, preventing any further significant fiscal stimulus. High labor costs and massive tax burdens are driving German firms to relocate production facilities abroad. An International Monetary Fund study in April noted that there was a considerable probability that deflation would take hold over the next year. The last thing German industry needs now is a rising euro.

As bbc economics correspondent Andrew Walker wrote, “Deflation is so pernicious because it makes debts more burdensome: Personal incomes and profits may fall but debts do not and so they become harder to repay” (May 29).

If the Dollar Should Fall Further

So far, the decline in the value of the dollar has been seen as positive for the U.S. However, should the dollar continue its downward spiral, the consequences could be catastrophic.

Traditionally, the U.S. has had a “strong dollar policy.” During the boom of the 1990s, such a policy helped contain inflation. In today’s climate, inflation is of little concern and all focus is on stimulating economic activity. But the Treasury walks a fine line between promoting a dollar policy that creates an environment conducive to exporting and one that goes too far, thereby damaging the environment necessary to attract adequate foreign investment.

The U.S. relies heavily on foreign investment to finance its chronic deficits. A declining dollar erodes the value of U.S.-denominated assets held by foreigners. As Christopher Swann wrote in the Financial Times, “The great fear for the U.S. would be that such an explicit abandonment of the strong dollar policy would undermine confidence in the currency, promoting an exodus of investors from U.S. bonds and pushing up interest rates” (May 20).

Since the end of World War ii, the U.S. dollar has been the dominant currency in the world. America has been regarded as a safe place to store wealth, both on the personal level and on the national level (foreign exchange reserves). This has especially been so during times of financial crisis such as the Mexican banking crisis in 1994-1995 and the Asian financial meltdown in 1997.

But with declining asset values, foreign investors may be forced to take their investments elsewhere, placing wealth in safer havens such as gold or buying up assets denominated in a currency where value will be protected.

Capital Flight

With Japan desperately trying to devalue the yen in an attempt to keep it on par with the dollar, the obvious place for investors to protect their assets is in Europe. Further declines in the dollar could result in a massive capital flight from the dollar to the euro.

Such a flight of capital could have catastrophic effects on the U.S. economy as the country attempts to finance chronic deficits. At the same time, it could open up access to new and cheaper sources of funding across Europe.

The Financial Times stated, “With the current account deficit approaching $600 billion this year, the U.S. needs to attract around a net $2.7 billion of overseas funds every working day. This will become ever harder if the market starts to fear that the dollar’s fall will be allowed to gather pace” (ibid.).

Swann also wrote, “The dollar’s slide is now forcing companies and investors to protect themselves against further falls in the dollar, which will erode the value of their U.S. assets or undermine their position in the U.S. market. Overseas investors own about 45 percent of U.S. government bonds, 35 percent of corporate bonds and 12 percent of equities and have been taking urgent steps to protect their huge stake in the U.S. economy. Since hedging the currency involves selling the dollar forward, there is a risk of a vicious cycle developing, analysts said” (ibid.).

While the current slide in the dollar’s value has, so far, been beneficial to the United States, markets can turn on a dime. Further devaluation could severely disrupt asset markets, sending huge waves rippling through the economy and pushing the dollar into a financial abyss!