Nov 13 2007

“What’s sinking the dollar?” – for IB students

What’s sinking the dollar? – November 26, 2007

The US dollar has continued its downward spiral against the currencies of many of its trading partners. Today an American wanting to exchange his or her dollar for a Euro would have to fork over $1.46; for a British Pound, $2.07, and for a Canadian dollar, $1.05! It’s been 35 years since the Canadian dollar was even near parity ($1US = $1CA)! But what are the real forces behind this continually sinking dollar? This article lays it out straight and clear:

The forces behind the dollar’s weakening have been building for years but didn’t have much effect until recently. Most fundamentally, we Americans have been living beyond our means, buying more from the rest of the world than the world buys from us (that’s the trade deficit); to do that, we have to give foreigners claims on our assets in the form of government bonds and corporate bonds, or sometimes the assets themselves. A country as rich as America can do that for a long time, but eventually the world ends up holding more dollars than there is dollar-denominated stuff they want to buy, so they start offloading dollars. They also worry that any country with loads of debt–even the U.S.–may be tempted to inflate its currency, and that fear reduces its value.

Since the U.S. has been running huge trade deficits the past several years–about $700 billion this year–the stage has long been set for the dollar to drop. What shoved it over the edge was the subprime mess and worries about a U.S. economic downturn. If the economy looks to be slowing down, investors bail out of U.S. assets and turn to investments that must be bought with other currencies. When the Fed tries to perk up the economy by cutting interest rates, as it has done twice recently, it makes the dollar even less attractive because investors can get better rates in other currencies, such as the euro.

What makes investors really nervous is that the trend could become self-reinforcing. A Chinese government official sparked a particularly sharp selloff of the dollar when he said his government would be moving its reserves out of weak currencies and into strong ones–goodbye, dollar; hello, euro. Since China holds more than $1 trillion, its actions could move markets, pushing the dollar down further, prompting dollar holders to shift out of it further, and so on.

Even if we avoid that scenario, more dollar weakness is probably ahead, at least relative to China’s yuan and other currencies of developing nations. As Alan Greenspan points out, when their living standards are rising faster than ours, their currencies will probably appreciate vs. ours. Remember, he says, that the Japanese yen was once 300 to the dollar and eventually strengthened to below 100 (it’s now around 113). The trend continues: In just the past year the dollar has weakened 13% vs. the Indian rupee and 11% vs. the Colombian peso, for example.

By the way, Warren Buffett told us all this would happen. In mid 2002, for the first time in his life, he began buying foreign currencies, thus betting against the dollar. He explained his reasons most extensively in a FORTUNE article he wrote (Nov. 10, 2003; see fortune.com). The main factor he cited, the trade deficit, is much worse now. For a year or two after the article, his bet seemed to be a loser. But now, as usual, he looks prescient. To top of page

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

3 responses so far

3 Responses to ““What’s sinking the dollar?” – for IB students”

  1. Marco Garofaloon 15 Nov 2007 at 10:24 am

    This is exactly what my EE is about. Americans are buying too much and selling too little and this has come back to haunt them. The issuing of government bonds (certificates of debt) is funding the deficit spending, but the US does not have any intention of repaying it. As the article points out, "a country as rich as the US can do that for a long time." But when foreigners own more dollars than Americans do, investors start to worry, especially when the Chinese say they want to move from weak currencies to strong currencies. If the Chinese sell all their US bonds, around $1.1 trillion worth, there could be dire consequences for the US economy.

    With the US$ falling against many of the other currencies, the US consumers are finding foreign goods more expensive. They therefore HAVE to consume less, which will narrow the current account deficit.

  2. optional.xuon 15 Nov 2007 at 10:12 pm

    So that's whats really causing the dollar to be going down so fast. The US economy has really taken a beating along with many other countries' economies with the soaring oil prices. The debt, most of it from the $%#@@! president, isn't being fixed but actually exacerbated especially from the war in Iraq! Economically, this is devastating as the post mentions that the debts are increasing and the economy is failing. So why is Bush spending more and more on "defense" when the "homeland" is about to fall apart? Oh right, I forgot it's election year next year… Mess it up as much as you can before you get out eh?

  3. Nicoon 17 Nov 2007 at 6:08 pm

    The US government buys too much from over seas and does not buy enough from the rest of the world. I think that the US is trying to save up its supply for the future, so when everyone else is low on supply, US will have supply left, and therefore can charge any price to the rest of the world. The US, for example, have plenty of area's to pump up oil with. Many of them the government has decided to leave untouched for the future. The US buy their oil from around the world. This results in the dollar inflating. In the short run US could suffer many problems if they continue to buy so much from the rest of the world without exporting much. But in the future, US's economy shall boom.