The Consequences of a Declining DollarUnless you spent last year in an isolated monastery, chances are you’ve heard about the declining U.S. Dollar. Regardless of which news publication you read, you’re probably aware that influential economists, policy makers, and experts of every flavor have had something (rarely good) to say about the weakening greenback.



Yet the layman often finds himself unsure of what this means, and many questions go unanswered: Why is the Dollar declining? Is it necessarily a bad thing? Business Today’s Online Journal decided to tackle these questions at the basic level to give you an idea of what’s going on in the economy with respect to the declining Dollar.

Let’s start with Monetary Policy 101. Remember that the value of the Dollar depends on the same things that decide the value of all goods: supply and demand. If you have a fixed quantity of dollars (which isn’t the case, but this approximation will suffice for now) and a lot of European investors want to get their hands on them, the person who sells the dollar can sell it for more Euros. If, tomorrow, fewer Europeans want Dollars, the equilibrium “asking price” for a dollar has to go down. You thus arrive at a conversion rate. At time of writing, for example, given the number of Dollars demanded by Euro-holders, a dollar can be traded in for .68 Euros. When people talk about a declining dollar, they refer to the fact that what a dollar can be traded for has gone down. A few years ago, that same dollar could have been traded for 1.2 Euros. This decline in the Dollar’s value suggests that global demand for the Dollar has fallen.

Why? For starters, recent reports show that consumers are spending less, people are less interested in buying houses, the price of oil is rising, and people are becoming more uncertain about buying big-ticket items like cars. This news, along with the subprime mortgage meltdown this summer, makes many worry about the state of the American economy as a whole. And when American assets are in trouble, investors around the world prefer to keep their money away from them. This means that they no longer require dollars, and consequently, demand for the dollar declines.

Other reasons for the decline in the dollar’s value are more long term and involve supply. Concern over national debt is one of them. In order to fund domestic projects as well as wars overseas, the U.S. Treasury Department issues bonds – I.O.U.s that anyone can buy now with the promise of payment in the future. Often, the buyers of these bonds are nations: China has chosen not to spend a large amount of U.S. Dollars it earns from exports, choosing instead to invest them in these bonds (in other words, China is holding on to U.S. Dollars in reserve in the form of bonds). While U.S. Treasury bonds are considered one of the safest types of investment, governments like China’s have become increasingly concerned that if the United States issues too many bonds, its debt will rise to a level at which it will be unable to fulfill future payment obligations. In light of such fears, China has become hesitant to hold onto more U.S. Dollars in its reserve, thus increasing the supply of the Dollar worldwide, and consequently diminishing its value. Even if China is confident that the United States will pay its debts, as the value of the dollar declines, China becomes increasingly tempted to reduce its dollar reserves before they completely lose value. This, in turn, fuels a vicious cycle of a rapidly increasing dollar supply, and increasing depreciation of the dollar.

Having understood why the dollar has depreciated, we may now better understand the effects of this drop. First, though, it is notable that the American Dollar is unique in that it has long stood as the pillar of international financial markets. Due to the strength and stability of the American economy since World War II, many nations have pegged their currencies to the Dollar. That is, each unit of such a foreign currency is backed by American Dollars in the nation’s currency reserves. Thus, if the dollar fluctuates wildly, so does every currency pegged to it. Even nations that peg to a “basket” of several currencies like the Euro and the Pound Sterling often have a large amount of dollars in their reserves and are thus affected. The dollar has assumed, in a sense, the role of the world’s common currency. As German publication Der Spiegel stated flatly, “The world depends on the dollar. It is the most important currency in global trade. Aircraft, oil, steel and most natural resources are priced in the US currency. Central banks around the world invest a substantial share of their currency reserves in dollars. The competitiveness of entire continents depends on changes in the value of the world's reserve currency.”

Perhaps the first clear losers in the event of dollar depreciation are foreign based companies that do a lot of business in the United States. Take Mercedefiat, a La-La Nation widget manufacturer. In 2002, Mercedefiat made a profit of $3 on a widget it sold in the United States, and this converted to 6 La-La Nation dollars under the exchange rate at the time. Given the lower value of the dollar today, that same $3 profit in the United States only yields 3 La-La Nation dollars under the current exchange rate. As a result, Mercedefiat would report lower profits and – like European aircraft and car manufacturers today – have to toy with the idea of layoffs. As a result, the overall La-La Nation economy suffers. Some of this would be mitigated by the fact that La-La Nation can buy the same $75 per barrel oil with fewer La-La Nation dollars than before, but this does not effectively counter job loss or lower profits (and note that in the real world, the price of oil has continued rising over the past year).

On the flip side, a clear winner is the overseas investor interested in American assets. With the same amount of capital, he can get more dollars under the favorable exchange rate, making costly purchases now affordable. Indeed, as the value of the dollar has declined, overseas investment in the United States has increased. As the Online Journal reported earlier, Arab investors in particular have acquired a notable share of American companies. In the past, some buy-outs have been of ports, sparking debates about a possible national security risk. In an election year as the dollar continues to slide, chances are good that buy-outs of American assets will raise public tensions.

As for perhaps the most important group – the average American – it’s a mixed blessing. On one hand, Americans have suffered massive trade deficits due to a strong dollar: American exports suffered the same fate as Mercedefiat’s imports into the US. As the value of the dollar declines, manufacturers are finally able to sell competitively overseas. In an article entitled “Who’s Afraid of a Falling Dollar?”, Mark Weisbrot, Co-Director of the Center for Economic and Policy Research, argues that the dollar’s decline is a blessing in disguise.

“It is because of many years of overvaluation that we have run up an enormous trade (and current account) deficit, borrowing from the rest of the world at an unsustainable pace. This borrowing will have to slow, and the way this will happen is through an adjustment in the dollar. This will reduce our imports and increase exports. In fact, it appears to be beginning already, as a result of the dollar's decline: Exports of goods rose by a 23 percent annual rate in the third quarter of this year, the fastest such jump since 1989… The alternative to reducing the trade deficit through the dollar falling is to have a serious recession, which reduces spending on imports. This is a much uglier process, and one of the main reasons why the world long ago abandoned the gold standard.”

In fact, Weisbrot argues that the reason the declining dollar causes panic in the United States is not due to some fundamental economic issue but that Wall Street carries too much influence. He points to two Secretaries of Treasury – Henry Paulson and Robert Rubin, both formerly of Goldman Sachs – and says that their primary interest has been to keep inflation down to a level that hurts the nation at large because it helps financiers. “When unemployment goes up, the bond market generally rallies. That is a reflection of the financial sector's direct interest in lower inflation and lower wage growth even if it hurts the vast majority of the country. … On the flip side, as the dollar adjusts to a more sustainable level, at least some increase in inflation is inevitable as import prices increase.” Indeed, Weisbrot suggests that we should embrace the declining dollar, at least for now.

Such a view has a historical precedent. In the 1970s, American policy makers deliberately weakened the U.S. Dollar with hopes of strengthening American exports and remaining competitive alongside Europe. John Connally, Secretary of the Treasury at the time even casually remarked that “The dollar is our currency, but your problem." Nicolas Sarkozy, the usually pro-American President of France, has openly stated his suspicions that the United States may be doing the same thing again. He has gone so far as to threaten economic war with the United States.

Not everyone is as optimistic as Weisbrot, however. Eduardo Porter and Mark Landler of the International Herald Tribune point out glaring flaws with supporters of the weak dollar who cite decreasing the trade deficit. Most important is the fact that compared to Asian trading partners, the dollar has not depreciated much. The Japanese Yen, for example, is also a weak currency, and has depreciated faster than the dollar. As a net result, the dollar has actually become stronger compared with the Yen. Of even greater importance is the Chinese Yuan, whose value relative to the U.S. Dollar is carefully controlled to maintain it at a low value, as per government policy. While the Euro has appreciated 40% against the U.S. Dollar over the last year, the Yuan has appreciated only 6.3%, largely a result of introducing foreign currencies to China’s currency reserves. And despite attempts by Secretary Henry Paulson, it appears unlikely that China will re-value the Yuan. Given this, it remains unlikely that the trade gap with China will close in the near future.

Then what’s the worst case scenario? If the trade gap does not close, a weak dollar’s lasting impact on the U.S. economy may well be inflation. As prices of goods rise due to costly exports or uncompetitive domestic goods, inflation could rise. "If the crisis continues well into the coming year," says Michael Burda of the University of Humboldt, "it may very well assume proportions like the worldwide depression in the 1930s." This is the most horrific of situations: a dollar so weak that inflation rises through the roof and begins to reach record levels without any measurable change in the trade gap. Worst yet, in the face of weak financial markets, the Federal Reserve may be unable to change the interest rate. Job losses rise while confidence in the economy plummets, wrecking consumer spending – the ultimate pillar of the American economy. Recession or even depression would then ensue.

While few economists are going to the papers with forecasts of the worst depression since the 1930s, most acknowledge that hard times are imminent as a recession looms. The decline of the dollar is both a cause and a symptom of this weak economy, and while far from being the only one, it remains one that U.S. policy makers need to address. So far, the Bush administration has urged caution before acting. While acknowledging that recent economic performance has not been rosy, the President urged a careful evaluation of options instead of a rapid solution. When the administration will propose a plan with an emphasis on sound monetary policy remains indeterminate, but it is clear that the issue can no longer be ignored.