Strengthening the Greenback

By wmadministrator

U. S. dollar coming down a hill
U. S. dollar took a bad spill
Can all the Fed’s resources
And the Treasury’s men
Put the U. S. dollar back together again?

Unlike Humpty Dumpty, the international value of the dollar has not been sitting on a wall. It has been on a downward path since the beginning of 2002, stumbling during 2007 before taking its recent tumble.

Measured against a trade-weighted basket of 26 other currencies, the dollar declined 17.2 percent from February 2002 to February 2007, an average of 3.4 percent per year. Its one-year downward velocity accelerated to 8.8 percent between February 2007 and February 2008.

The general decline of the dollar’s value since early 2002 has been due to the large and increasing deficits in the U.S. trade balance. Between 1975 and 2007 our imports of goods and services have exceeded our exports of goods and services, year in and year out. The total trade deficit since 1975 has been more than $6.3 trillion, with $4.1 trillion, or 65 percent, occurring since 2001. In 2007 alone the deficit was $712 billion, of which $265.3 billion was with China.

The large and increasing trade deficits set the stage for the dollar’s tumble in early 2008. What tripped the dollar in early 2008 was a faltering in the confidence of foreigners in the stability of U.S. financial markets and the soundness of U.S. financial institutions.  This declining confidence is clearly indicated in the value of the dollar versus the euro.  Between 2002 and 2007 the dollar fell 33.4 percent against the euro, an average of 6.7 percent per year. The drop between February 2007 and February 2008 was 11.4 percent, and between Feb. 1, 2008, and the middle of March the fall was 4.8 percent.

The main reason that the United States has been able to run persistent and increasing trade deficits since 1975 has been that foreigners have been willing to hold increasing amounts of dollars as deposits in U.S. banks and as investments in U.S. securities markets. Since World War II, the U.S. dollar has been the world’s “key currency,” i.e., the currency in which transactions have largely been denominated and in which foreign governments and residents have held liquid reserves and readily marketable assets. The reign of the U.S. dollar as the world’s key currency could be coming to an end.

The bit of good news in the dollar’s decline is that U.S. exports should increase as U.S. goods and services become cheaper to foreign buyers. Also, U.S. imports should decrease as U.S. residents find foreign goods and services (including travel) more costly.  The U.S. trade deficit should therefore shrink. However, the bad news is that all this will be inflationary. Already quite evident are inflationary impacts on the prices of food, fiber, basic metals and petroleum products. The outlook is for more of the same. Currently the Fed’s ability to fight inflation is totally vitiated by the need for low interest rates to keep recession at bay and stabilize securities markets. It is one of those times when economics deserves to be called the “dismal science.” Dramatic changes in national policies are very much needed.

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