May 22 2008
What do you believe is the most direct cause(s) of the weakening of the dollar? Is it the trade deficit and/or spending deficits along with increased borrowing overseas? Is it offshoring? Tax cuts? And how direct is the causality of this to oil and commodity prices?
Of course I'll give you full credit in the post for educating me more on this subject. Thanks in advance !
Below is my reply. I am posting it here for posterity, and because I think it may include one possible explanation of the weak dollar within the grasp of IB and AP Econ students:
Keep in mind, I'm no expert here, only a high school economics teacher… but let me just share a few thoughts about one cause of the weak dollar.
I think something you've forgotten to mention in your email is the role that the mortgage crisis has had on the dollar. Much of the debt from the sub-prime mortgage market was held by overseas investors. As home foreclosures picked up late last year, confidence in these mortgage-backed securities plummeted and demand for these American assets fell, thus demand for dollars among foreign investors has fallen with it, depreciating the dollar.
I think the housing market is at the core of a lot of our woes right now. In my econ class we talk about the “wealth effect” of falling home prices on consumer spending. Besides disposable income, the main determinant of overall consumption in the economy is the level of “wealth” among households. Of course, Americans' greatest source of wealth is their homes… and the reason home prices have fallen is a simple supply and demand story, which is within the grasps of anyone who knows how supply and demand interact to determine price in a marketplace.
Low interest rates during the late Greenspan era spurred a period of new home sales, which drove prices up, spurring a building frenzy which shifted supply out. As long as demand increased more rapidly than supply, the illusion that house prices would continually rise was believable, thus buyers could be convinced that an adjustable rate mortgage (ARM) was the perfect type of loan for them. But the rising prices were unsustainable, and when the Fed began increasing interest rates a few years ago, demand for new homes declined, right as inventory was at an all time high. Naturally, home prices began to stabilize then fall, and as the “adjustable” part of all those “sub-prime” ARMs kicked in, monthly payments became too much for some Americans to bear. In an attempt to liquidate their now unaffordable houses, millions of Americans put their homes for sale, while thousands began to default on their loans, both which combined to shift supply ever further outward, putting even more downward pressure on home prices.
The story continues from here: falling home prices mean less “wealth” which means less consumer spending which means less total output in the economy which means less demand for workers which means rising unemployment… aka, RECESSION! And that's where we are today.
So, as you can see I think the housing market is at the core of our problems. The weak dollar too, as demand for American homeowners' debt has declined among foreign investors. Now, in the face of a recession, the Fed has lowered interest rates once again to try and stimulate new spending and investment, further exacerbating the dollar's decline, as lower returns in the US bond market divert investors out of dollars and into more secure investments, such as… you guessed it, OIL.
The falling dollar had encouraged investors to look for stable investments, such as commodities like oil, copper, coal, etc, driving demand and prices for these commodities up, contributing to the cost-push inflation that has accompanied America's economics slowdown.
So yes, it's all connected… rising unemployment, sluggish growth, rising price levels and falling real wages. At the core, however, is the housing market and the “irrational exuberance” that led to a speculative building and buying spree over the last six years: a bubble which began bursting late last year and continues to have a ripple effect across the economy.
Bush's tax cuts and deficit spending just made this whole mess even worse. I did a blog post a while back about the trade deficit with China, budget deficits and the value of the dollar, you can read that here: “Excuse me China, could you lend us another billion?”
Okay, that's all I've got for you today… I hope some of these observations are useful!