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I was playing with a dollar bill at the local Starbucks (NASDAQ:SBUX) this evening, on my way back from another long day at work. A friend who was waiting in line to get his coffee nonchalantly announced, “There was a time when I used to buy a gallon of gas with that piece of paper.” I initially thought that the comment was just a 50-year-old reminiscing about good old times and what could’ve been. But then upon returning home, I started thinking about what it takes to resurrect the dollar and how the dollar got here in the first place.

First, to understand the pain-point, just remember your most recent trip to Europe or even Canada. Didn’t the trip cost you an arm and a leg compared to good ol’ times? It’s difficult for me and for all of us. My friend from Starbucks leads me to believe that most older Americans have never seen or lived in a world in when the dollar didn’t rule. The current state of the dollar is simply un-American, and this led me to research and write this blog post. 

From 1971 onwards, the trading of most major currencies has been similar to the market for food-grains and commodities and dictated by the basic laws of supply and demand. The trade status of a country decided the supply and demand curves for its currency. For example, if the U.S. was buying more wool from Australia than it was selling technology back to Australia, then the US$ would decline against the Australian $. But if Australia had an pandemic outbreak of sheep disease one year, the trade balance shifted towards U.S. and the US $ rallied upward. 

The dollar grew in status and became a sort of world currency as it was perceived to be robust against trade fluctuations. It became the currency of choice between countries with different currency denominations, and a country’s economy and wealth started getting measured in terms of the U.S. dollar. The dollar grew to megalomaniac proportions over the decades, independent of the actual status of U.S. trade and economy.

As the American economy flourished, the demand of its citizens for foreign products (imports) exploded, whereas the capability of the U.S. to produce and export products to the world did not. The heights reached by the dollar (read  global demand) during this time shielded the economy and also the dollar—no other country or currency could’ve survived an imbalance of this proportion. As a currency falls, the country’s exports become cheaper and its imports become expensive. 

This exclusive capacity of the U.S. economy to absorb huge amounts of imports for an extended period of time, courtesy the dollar, became an opportunity for others. Japan spearheaded this by developing products specifically for sale in the U.S. market. American consumerism drove the creation of large numbers of jobs in Japan and was a dependable factor for the Japanese to bank their industrialization and trade strategies on.

This continued to happen as the U.S. economy was resilient enough to continue consuming more and more Japanese goods despite the exports back to Japan being only a fraction of the imports. America continued to balance this trade imbalance by instead exporting dollars into Japan. Dollar was commoditized even more through our consumerism. The strength of the dollar became its eventual weakness. The Japanese, on the other hand, kept their currency weak to ensure that their goods continue to attract the U.S. consumers—as a result, the U.S. dollar became artificially strong against the yen to support low-price TVs, cars and other Japanese goods. 

Bank of Japan did this by purchasing more US dollars and Treasury bonds even while the trade deficits grew larger and larger by the day. This enabled them to become creditors to the U.S. economy.

This Japanese formula was adopted by other countries such as Korea, Taiwan and others as well, but no one did this as well as the Chinese. The Chinese currency was highly regulated and artificially pegged at 1:7 for the longest time. Keeping the exchange rate low and constant enabled the Chinese to develop products and goods for American consumers who only wanted more and cheap. As a result the Chinese export/import deficit with the US grew to 321B:65B (appx 5:1) in 2007.

Just like Bank of Japan, Bank of China bought and continues to buy massive amounts of U.S. Bonds and other dollar denominated assets despite the risk that these assets will decline significantly in value, due to the weakening dollar. This is the Chinese strategy to sustain their GDP growth rate of 10%/year.

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We owe $10 trillion to foreign creditors against $7 trillion owed to us by foreign debtors. The net debt of approx $3 trillion is 10 times higher than what it was little over a decade ago. Of course, it's magnitudes of times higher than most GDPs in the world!

This U.S. national debt will increase significantly again this year with the continuing trade deficit in 2008, which is already at 100B (in 5 months Jan-May). The other factor that will contribute to a significant increase in this debt is the federal bail-out plan for financial institutions and GSEs. For example, Fannie (FNM) and Freddie (FRE) both will need important dollars which will most likely be financed through sale of bonds, and it's not obvious who will lap these up for sure. Our economy’s decline is another economy’s safety-net and growth in current economic conditions.

In addition, the interest, rent or dividends that are due to foreigners who own U.S. assets adds even more to the debt—so if the interest rates go up 6 months from now (as signs point to and per my analysis), our national debt will continue to grow. To understand this, just imagine if interest rates on a debt of 3 trillion jumped up by 3-4 percentage points. We are talking about an additional 60-100B dollars in debt to be repaid. On the brighter side, increasing the interest rates makes the American economy more lucrative to foreign capital and American capital which otherwise gets invested globally. This creates job and bolsters our economy.


What’s next?

The foreign economies have to do what they do to sustain themselves. But we do run the risk of the dollar declining and crashing—this has global ramifications. The status of the dollar has never been reached by any other currency and no other economy has been so dominant as the U.S. economy, so there’s no precedent or history to look back on. 

Global depressions have been rooted in currency problems. The great depression of the 1920s was directly tied to trade being carried out in gold, and the United States had been so dominant in trading with Europe that a huge portion of the world’s gold ended up there. As a result Europe became cash-starved and its inability to buy American goods meant America's economy had over-capacity, which led to the melt-down in the Stock market, which deemed American stocks overvalued. It wasn’t until the War years that the over-investment in capacity was truly realized by re-purposing it to supply the global demand for wartime products and goods.

If the American capacity to buy foreign goods declines, it may create a similar melt-down albeit given the globalization and redistribution of wealth that has happened in the recent years, its impact and effect may not be as immediate as in the 1920s. Continuing with our Japan and China example, I believe both nations have wasted an opportunity to reinvest the dollars into consumer, technology and other goods sourced from America to keep the trade balanced, instead of investing in American debt. They stand to lose if the dollar doesn’t rebound. If the dollar weakens, then manufacturing and production of goods which disappeared from the U.S. will make a comeback domestically—not sure how immediate or permanent this would be—but worth keeping in mind as it’ll change the trade dynamics for sure.

 A strategy that may help in the short-term is the revaluation of the artificially pegged Chinese currency (Yuan). This artificial imbalance is accelerating the decline of the dollar, which is not in anyone’s interest. Additionally, the US economic policymakers should take immediate steps to address our trade and budget deficits. 

A weak dollar paints a very bleak future for one and all. What say you?

Source: Who Moved My Dollar?