November 22, 2004Currency Markets and the DollarThe latest Wall Street fixation is with the declining dollar. Make no mistake, the decline does carry some real risks, and not just that people won't be able to afford those trips to Paris they've stopped taking. The weaker dollar is partly and attempt to close the trade deficit, which clearly can't keep going at 5% of GDP forever. But both the trade deficit, by definition, and the budget deficit are being financed by foreign investors in the US economy, buying up government and corporate debt. The potential problem is that a declining dollar makes those investments less attractive, since foreigners will be paid back in cheaper dollars, meaning they'll get less back of their own currency when they cash in. In order to continue to attract foreign investment at rates necessary to finance the deficits, the Fed may have to raise short-term interest rates, hurting the economic recovery and, incidentally, making investment in the US less attractive economically. There's also a risk of inflation. Usually, this is cited as coming from more expensive imports, since it takes more dollars to buy those yen- and yuan-denominated goods. The other, possibly more important source of inflation would come from a loss of confidence in the dollar. If other countries see the dollar as weaker, they'll be less likely to use it as the international "reserve currency," or the currency that foreign treasuries hold in reserve in case theirs, or that of a major trading partner, hits a rough patch. If many foreign treasuries were to come to the conclusion that they needed to hedge their bets, they would sell dollars, increasing the number in circulation, raising the dollar money supply without increasing the amount of goods on the market. By definition, that would increase the number of dollars it took to buy something - inflation. For reasons discussed below, this is the more dangerous source of price increases. The administration, despite its talk of a strong dollar policy, not only hasn't done much to stop its slide, there's probably not much that it can do aside from psychology. Trillions of dollars each day are traded on the world currency markets, and no country's treasury has enough money to keep buying high and selling low for very long. A currency panic, such as what happened to England when it was forced to abandon the European currency agreement, would be impossible to derail once it got going. (More troublingly, George Soros has demonstrated the market authority to help create, and the savvy to exploit such a crisis, which could certainly make life pretty miserable both for his adopted country and his nemesis, the President.) On paragraph sticks out though: Some European leaders sharply criticized the U.S. for failing to take action on the dollar - and cited that inaction as a reason why Europe wasn't moving as quickly at the U.S. would like to overhaul its labor and regulatory systems. "You can hardly demand from the Europeans to constantly carry out structural reforms - which we are doing - without addressing your own needs as quickly as, from our point of view, would be necessary," German Chancellor Gerhard Schroder said. This is like the child who, having waited to get ready for the car trip until the last minute, suddenly says he needs to go to the bathroom. That the Europeans have dawdled on reform for decades, and are only now taking baby steps in that direction, takes some of the starch out of their complaints. There's no doubt that their exporters are being hurt by the same currency swings they once benefitted from. But European central bankers have a fixation of their own with budget deficits that has hampered their own reform, and their own economic growth. There's no doubt that one export they'd like to make to us is their own anemic GDP growth. That said, the US economy has grown during strong and weak dollar periods, and can almost certainly handle and orderly decline. It's nowhere near all-time lows, and there's no sign of a panic that would send the currency into a tailspin. Markets almost always figure stuff out before governments do. So short-term interest rates have been rising in response to the Fed increases, long-term rates have barely budged. This suggests that investors haven't lost confidence in the dollar - they figure over the long term it's a strong currency, and will bubble back up just as it's drifting lower now. Posted by joshuasharf at November 22, 2004 06:31 PM | TrackBack |
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