The Declining Dollar: Can It Be Saved?

The decline in the value of the dollar has gotten increasing headlines since the Federal Reserve Board of Governors released its new monetary policy efforts on Tuesday. Many short run reasons are being given for the recent decline in the value of the dollar, especially against the Euro and the Yen.

The most intriguing explanation for the decline, however, is a longer-term reason. In this explanation, analysts argue that the decline in the value of the dollar is just a continuation of the trend, which began in early 2002 and continued through until early August 2008.

The story that accompanies this explanation is that a series of events in 2001 and 2002 convinced international markets that the United States government had forfeited any discipline it had established over its fiscal and monetary policies. First, there was the huge Bush (43) tax cut that moved the government’s budget from one of surplus to one of deficit. This was followed by the war on terror and the Iraq invasion, which exacerbated the amount of the budget deficit.

In addition to this the Greenspan Federal Reserve cut the target Federal Funds rate to very low levels, around 1% or so, for a period of about two years. Mr. Greenspan’s concern, apparently, was fear of an extended recession following the burst of the dot.com bubble in the stock market. The result was the creation of the housing bubble as well as smaller bubbles in other areas of the economy, including commodity prices.

Massive amounts of debt were created because of these actions. Fortunately, for the United States, at the time, over 50% of this debt - both private and public debt - was financed outside of the United States. Large amounts were placed in China, India, and the Middle East, although as we found out, banks all over the world acquired huge quantities of mortgage-backed debt.

The interesting thing that was learned from this period is that consumer inflation (as measured by the Consumer Price Index) could be kept in check while inflation ran rapid in asset prices (particularly in housing prices and commodity prices at this time). The monetary authorities concentrated on consumer prices and did nothing with respect to asset prices.

The thing is that “self-reinforcing expectations” can be built into asset prices leading to a massive increase of financial leverage. Consumer credit can be expanded for purchases of the items individuals purchase, but this credit expansion cannot match the possibilities for increase that exist as asset prices go up substantially, year-after-year.

Foreign exchange rates capture the relative expectations of people that operate in these markets. The specific ‘relative expectations’ that are relevant here pertain to how market participants judge how the economies of different countries are expected to perform. Performance in this instance relates to the state of the economy, performance of government’s in terms of their conduct of their economic policies, and expected inflation.

In this respect, Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, has stated that the price of a country’s currency is the most important price in its economy. The value of a country’s currency is, in a real sense, the “grade card” of the country’s economic and monetary policy, relative to the rest of the world.

Thus, as the value of the United States dollar fell more than 40% from early 2002 to August 2008, participants in international financial markets were indicating a belief that the government of the United States was showing little or no discipline over its budget and this was connected with an extremely “loose” monetary policy. To these market participants, the United States would have to “pay the piper,” sooner or later.

As the story continues, when the financial markets fell apart in September, the United States dollar became the “quality” asset in the world and investors flocked to the dollar as they repatriated assets from all over the globe in order to invest in U. S. Treasury securities. As a consequence of this rush to quality, the value of the United States dollar rose.

This latter movement has apparently come to an end. There seems to be a number of short-run reasons for the recent decline in the value of the United States dollar…one of them being a move on the part of foreign investors to get back into their own currencies to dress up their year-end balance sheets.

But, there is another reason given for the drop in the value of the dollar and this is connected with the decisions of the Federal Reserve that were announced on Tuesday and the projected rise in the deficit of the federal government. For all intents and purposes, the target Federal Funds rate is now approximately zero. In addition, the Fed said that it would buy financial assets, long-term U. S. Treasury issues and mortgage backed bonds and so forth in order to flood the financial markets with liquidity. Moreover, they warned, they will continue to do this for as long as necessary - whatever “necessary” means. On top of this, the Obama team seems to be talking about adding roughly $1.0 trillion in expenditures to the federal budget to get the United States economy going again.

One can easily draw from this the assumption that the world will be flooded with dollars -millions and millions of dollars. How should one react to this in terms of the value of the dollar?

One could argue that this is exactly what world financial markets have been predicting would happen since early in 2002. (They did not, and could not; predict precisely the path of the collapse.) This is exactly the reason why the United States dollar has declined by about 40% since then!

The problem is that there are no “good” decisions left for the United States. This is the dilemma that must be faced when discipline in lost. When one sees the consequences of a lack of discipline, one does what one needs to do in order to get one’s life back in order. Getting discipline back into one’s life is a matter of one-step, at a time.

In terms of priorities, getting the economy going and avoiding a cumulative collapse is number one. Until this is accomplished, we may just have to see the value of the dollar continue to decline.

Comments

[sickofthehype:]

ALERT!!!! ALERT!!!!! NEWSFLASH!!!!

$8 TRILLION in 'stimulus' will devalue the USD. I repeat, the USD will be devalued.

This article made me say 'duh' way too many times.

2008 Dec 18 12:19 PM

[bosun.j:]

"In terms of priorities, getting the economy going and avoiding a cumulative collapse is number one. Until this is accomplished, we may just have to see the value of the dollar continue to decline."

What we have here is a failure to accept reality.

There will be no "getting the economy going" The economic engine block is cracked so overhauling it is meaningless. It needs to be discarded and replaced with a more durable one.

There will be no "avoiding a cumulative collapse" because we are already well past the point of no return of this collapse.

The US dollar will continue to decline because we have shown the world the extremist-capitalist model is truly bankrupt.

2008 Dec 18 03:17 PM

[CJJ:]

I believe both comments above are true in some part, but as per usual have 2 common flaws:
sickofthehype: False Statistics
bosun: Certainty

sickofthehype: $8T has not been created or spent. And please refrain from finding some article breaking down all the money you claim to have been created or spent, it would be as useful as Nielson Ratings or that cute chart people keep putting out showing this use of money compared to WWII, The Louisiana purchase, etc.
With that said a lot is being thrown at this mess, however doing nothing would most likely be more expensive longer term. You could make a good argument not enough has been thrown at it.

That leads to bosun and the good point that the system is broken(which is probably correct) but that it is certainly not fixable is fallible and dangerous. People were certain the world was flat. People were certain the sun orbited the moon, the weatherman is certain about his weather forecast, Chad Johnson used to be certain the Bengals were going to win certain football games. Certainty often leads to failure and surprise.
Either way, they will probably continue to try to save this system while perhaps "tweaking" it to become more durable, but if it was simple, it wouldn't be a bad idea to come up with something new(although I'm sure it would get more of its fair share of criticism and challenge.)

2008 Dec 18 03:54 PM

[Greg Pinelli:]

Yo..CJJ..let's get a few facts straight..bosin.j may be precisely wrong but he's roughly right..whatever stimulus is provided to financial institutions in the "Please God save us" economy can be multiplied many times over in loans. The Fed has decided to go off line and will monetize whatever. Do YOU understand what that means? Do YOU think that is only what the newspapers print?
The US$ is going to have very rough seas and the Treasury and Fed don't care....this economy is NOT going down because of a few trillion here or there.

2008 Dec 18 08:26 PM

[Asbytec:]

Well, whether the system is broken or not is arguable, but it is over stretched at this point in any case. I, too, feel it must correct. And by correct, I mean collapse.

And we might just need a new system. Sure. But, when this one reboots, it will be good as new and run it's course for another hundred years.

But, all is not said and done for the dollar. Man, I don't feel like repeating myself from other threads...

And I'd make one distinction with Bosun, it's not extremist capitalism, it's extremist financialism that brought us to where we are.

2008 Dec 19 09:06 AM

[carey_jim:]

Don't forget Bretton Woods, i.e. politics.

No matter how much you want economics to function as a game of exchanging goods and services in a free market regulated by the players representatives, the government, economics is only an approximation of that ideal, even in the best of times.

In the worst of times we get Mao, Lenin and Hitler.

We need to get out of the box and start looking at history again which is our only reliable guide to our future.

2008 Dec 19 01:12 PM

[Kdager:]

A lot of credit (banks' assets), home values and investments (our assets) have been incinerated in the past year. That not only took the wind out of the economy... but the destruction of wealth also destroyed dollars just as the FRB has to sell more treasury securities, taking more dollars out of the economy. To some degree, isn't new money creation and government bail outs just replacing that? To the extent it is a replacement rather than an expansion of national debt and money supply, how is that inflationary? There are consequences to our government's rising debt replacing a declining level of America’s business and consumer debt. Higher taxes and regulation will depress economic growth, and be deflationary. The likelihood of the FRB someday reversing their stimulus when any recovery appears will also dampen that growth, restrain price increases, and raise interest rates. If the world is falling apart along with us and global chaos drives wealth to the "safest" countries, then the U.S. dollar might hold its own or strengthen. I sure can't tell you what to expect, but I won't join what seems like the cult of dollar decline and soaring gold. There are many variables. It seems that some who "believe in" a final outcome of dollar depreciation point to only those variables that deliver the outcome they believe in.

The flaw of economic education has been that colleges teach students: "shifting the demand curve outward against the... produces this result, all other factors remaining constant". Whatever the illustration it is only a certain outcome in theory. All other factors never remain constant in a complex world. I'd rather watch real trends for signs of continuation or reversal and deal with life's realities, rather than act on fears of what could happen from changes that worry us,... assuming all other variables remain constant.

2008 Dec 24 02:59 PM