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By Karl Smith

Kathleen Madigan writes

Once foreign appetite for U.S. securities wanes, look for a weaker dollar. On the plus side, a cheaper dollar will help U.S. exports (a plus for the current account). But a weaker currency eventually will push up import prices and overall inflation (a headache for the Fed).

The dollar’s vulnerability is the price the U.S. must pay for becoming so beholden to foreign investors. As long as the U.S. must borrow heavily to finance its trade and fiscal deficits, that dependency won’t change soon.

This gets the size of forces backwards.

That net financial flows into the US are so strong forces the dollar to rise to a point where the US runs a trade deficit wide enough to support it.

Financial flows are far bigger than trade flows and are driven in part by actors – like foreign Central Banks – who are not profit maximizers and do not have to adjust to every marginal change.

But, for foreigners to buy dollar denominated assets they must acquire dollars. The scramble to acquire dollars effectively results in a dollar shortage on the world markets. This process pushes up the value of the dollar and conversely net exports down until the amount of dollars leaving the US because of the trade deficit is enough to fund net purchases of dollar denominated assets.

You can see the strength of relative forces when in the middle of an economic collapse which began in the United States and was to result in a massive expansion of the fiscal deficit, the dollar sharply rose.

FRED Graph

Indeed, though the Fed is too polite to say, a major message behind QE2 was “Foreign Capital, Go Home!!!”

Source: Real Time Economics And Financial Flows