Archive for November 26th, 2008

What’s Up With the Dollar?

We have been spending a lot of time in my classes talking about the causes, consequences and possible cures for the current economic crisis.   It’s especially scary for students, realizing they are getting ready to enter the work world, and that they are being handed a debt of well over $10 trillion and an economy way out of sync.

Good students that they are, they maintain a bit of skepticism as to what their prof is telling them.  One astute student suggested that if my analysis was right, the dollar should be far weaker than it is.  The dollar, in fact, has been rallying.  Does that mean that perhaps our economy is better than many believe, and there is cause for optimism?  That is a very good and insightful question.

To be sure, I’m glad the dollar has shown strength recently.  We’re planning a travel course to Italy in February, and I hope the dollar rally lasts at least another quarter year.  We hope to offer a major travel course to Germany and Austria in May 2010, a high dollar then would be nice too.

Right now the dollar is at about $1.30 per Euro.   Historically, that is rather weak.  At one point back in 2000 it was 80 cents for a Euro, and for a long time a 1:1 ratio seemed like a relatively weak dollar.   Yet recently the dollar fall to about $1.60 per Euro, before the rally after the economic crisis began brought it up to almost $1.20 a Euro at one point.  At one level, given the bailout money, the weakened economy, and poor growth prospects looking forward, a strengthening dollar seems bizarre.  Can it last?

No.  The strong dollar is an illusion, a short term phenomenon caused by a variety of technical factors but most importantly the fact that the crisis is global and at least for now, dollars are trusted more than other currencies in a time of uncertainty.  There is also a belief by some that the US will actively pursue a strong dollar policy in order to spread the recession pain more widely.  However, when it comes to economics, the fundamentals can’t be denied.

First, the US still has a large current account deficit.  It is unlikely that foreigners will continue to finance that as American assets lose value.  A dirty little secret in the swiftness of Congress and the Executive to prop up many of these financials is the fear that if they are allowed to fail, foreign investors will be burned and start pulling out of the US, causing a run on the dollar.  Also, with investments declining and people selling, they needed to become liquid, and the dollar was a logical choice.  This points to a short term panic rally of the dollar, followed by a longer term dollar collapse.

So I have to say that I think the dollar’s current strength is, if not an illusion, a short term phenomenon.   At some point as the fed lowers rates, as US deficit spending grows, and it’s clear there isn’t going to be a sudden burst of economic activity in the US, there will be a dollar panic and we could see $2 to a Euro.   Now, the European economy isn’t exactly all sweetness and joy right now either, but they aren’t going to have to correct for a massive current accounts deficit like the US.

Practically, what does this mean?  First, oil will go back up in price when the dollar starts depreciating.  OPEC still prices oil in dollars, and if the dollar loses value, oil increases in dollar price (though  the increases are slower in other currencies).   The current drop in oil prices have been greater for us than the Europeans because of the dollars strength — it works both ways.  Second, we’ll get inflation.  Right now the concern is deflation due to decreased economic activity.  In a recession, with higher unemployment and decreased economic activity, inflation is usually not a problem.   Yet markets are now global, and so these things operate under different rules.   The only way to balance our current accounts is to depreciate the currency — the market will do that whether we like it or not.  Perhaps now is a good time to purchase some needed home goods or a new car, before inflation starts driving prices up.  If I had the money I’d dump dollars and American securities and go into foreign equities and currencies.  Oil stocks are a bargain now too — oil prices will go up.  Alternate fuels are being hit by current low oil prices, but they’ll come back too.

As investors decide to move from quick gain US investments in stocks and property (the ‘bubble investments’ of the last decade) to investments in actual production capacity and various global markets, the dollar has nothing to prop it up.   One student asked if all these massive bailouts might be setting up another bubble — throw so much money into the economy that credit remains cheap and speculators are able to find some new creative way to re-bubble the economy, lure in foreign capital to finance our trade and budget deficits, and keep the party going.

I think not — and I certainly hope not!  Every time we delay having to deal with the reality of our economic fundamentals, the ultimate price we’ll have to pay gets higher.  The higher the debt, the deeper the current accounts deficits, the more unstable both the dollar and the US economy becomes.  I think we were able to go from bubble to bubble in the last decade because the financial pundits and analysts never had a glimpse of the dark side of the economic illusion they were creating.  They convinced themselves that wealth creation was enough to offset debt, and wealth creation was measured in portfolio and investment values.  These were never real, they were artificially inflated buble values.  Now that it’s collapsed and people have been burned, I can’t imagine they’ll allow themselves to be burned again.  And even if enough short term greed were to allow some new bubble to form, peole would be quick to get out at the first sign of danger.

The fundamentals are clear and have been for about a decade.  We have been financing a life style beyond our means through unsustainable current accounts and budget deficits, using the power of our financial instutions and control of financial markets to allow this to be financed by foreign capital.   Such a situation cannot continue forever.   The painful rebalancing should have started with stock market crash, but after 9-11 credit was made so cheap and so much money poured into the system to prevent terrorism from bringing down the economy that we financed an even more dangerous bubble — a property bubble existing alongside bizarre financial instruments sold as investment grade securities.  Now, we pay the price.

If we’re entering a storm, we’re still at the outer bands, starting to feel the force of the winds, but with much more to come.   Once the dollar starts falling, foreign capital will bail from US markets quickly — as will American capital, since markets are global.  This will create a deep recession, accompanied by inflation, which will have the practical effect of lowering all our standards of living, and causing severe crisis to national, state and local budgets.   At some point, the storm will pass, and we’ll have to clean up the mess and find our place in a rebalanced world economy.

But there are two bits of good news here:  1)  We’ve been living in a kind of illusionary or fake economy for awhile now, the sooner we can get back to reality the better it will be in the long run; and perhaps the best news: 2) While I stand by analysis and note I’ve  been talking about the current accounts deficit, hyperconsumerism, and the ‘fake’ nature of our economy for years now, I’m a political scientist and not an economist.  I study political economy, but don’t get into the technical analyses.   So maybe I’m wrong.   I hope so.  I don’t think so, but I hope so!