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The Dollar's Decline and Its Implications

The Dollar's Decline and Its Implications

Some people are concerned that China, since it holds so much U.S. debt, might start dumping dollars on a wholesale basis. Most economists think that this scenario is rather unlikely. The fact is that if China started to dump our dollars, the dollar would go into a precipitous fall. With China holding so much in dollar-denominated assets, their national wealth and treasury would also plunge.

By Theodore F. di Stefano
12/14/07 5:00 AM PT

There is no doubt that the dollar seems to be heading in one direction: down. Though I have faith in the long-term prospects for the dollar, it's very important to be aware of the dynamics of a falling currency. Because the United States is an international economic powerhouse, the implications of a falling dollar are multifaceted and leave our leaders with some difficult alternatives as to how to create and apply a "fix."

The good news is that there are positive effects to a falling dollar. With a cheap dollar, foreigners can buy U.S. goods at a substantial "discount." Take the euro, for example. This currency is now worth about US$1.50 to the U.S. dollar. If the euro were at par to the dollar, our goods, services and real estate would cost the same for a European as they would for an American.

However, now that the euro is worth about 50 percent more than the dollar, its purchasing power has therefore increased a similar percentage. For example, if a European wanted to purchase some New York real estate that is for sale at $1 million, he could purchase that for about 685,000 euros. As the euro increases in value in relation to the dollar, American goods and services become proportionately cheaper.

Benefits of the Falling Dollar

You might rightly ask: How does this benefit us? The fact is there are several real benefits to this situation. For example, if money is flowing into the U.S. for the purchase of real estate, it provides some support for our faltering real estate market. The flow of foreign dollars into U.S. real estate increases the demand for that real estate, therefore shoring up prices.

There's another substantive way that the weak dollar helps us. With a weak dollar, our exports become correspondingly cheaper and more reasonably priced. This creates a demand for our exported products and services, thus helping with a serious problem that is caused by a history of exporting far less than we import. This problem is referred to as the current account deficit or the foreign exchange deficit. With our exports increasing, our employment rises accordingly and we generate income not only for our workers, but also for our manufacturers and other exporters of goods and services. This deficit of exports over imports is therefore helped by a weak dollar.

Incidentally, services can be exported, though the concept seems rather strange. Think of the outsourcing phenomenon and how many times you've picked up a phone to call a service line of a U.S. corporation only to talk to someone in India or some other foreign country.

Well, we also outsource our services, just as other countries outsource their services to us. With a cheaper dollar, other countries can afford to hire U.S. workers to handle phone calls and provide other services, just as we have been doing with foreign workers for years.

Negative Effects

Obviously, there are downsides to the falling dollar, one of which is the fact that our imports become correspondingly more expensive. This adds to an inflationary threat to U.S. consumers and to our economy.

Just think about what has happened with the price of gasoline. The high prices at the pump have been a major U.S. concern of late. A great deal of our energy is imported, thus we are forced to pay more for it. Surprisingly, this has not been too big a deal for foreign consumers of energy because oil is priced in dollars, and dollars have become cheaper for foreigners.

This situation becomes somewhat more complicated in that recently our economy has needed some help from the Feds because of, among other things, the faltering real estate market. In order to avoid a recession, the Feds have had to lower interest rates. On the face of it, this might seem like a great idea for the U.S. economy in that lower interest rates tend to stimulate the economy.

However, there is a downside to lowering interest rates. Since the U.S. owes trillions of dollars to foreign countries because of our consumer debt and government debt -- China alone holds over $1 trillion of dollar-denominated assets -- foreigners will be less willing to purchase our debt. It's simply not paying a high enough rate. As interest rates fall, our debt becomes less attractive to foreigners.

This has already caused some degree of flight from the dollar. I recently read that the highest paid international model no longer accepts fees in dollars and insists on getting euros instead. The dollar simply isn't as attractive as it used to be.

Will China Dump Massive Amounts of U.S. Dollars?

Some people are concerned that China, since it holds so much U.S. debt, might start dumping dollars on a wholesale basis. Most economists think that this scenario is rather unlikely. The fact is that if China started to dump our dollars, the dollar would go into a precipitous fall. With China holding so much in dollar-denominated assets, their national wealth and treasury would also plunge. For this reason, many economists are not overly worried about this kind of economic Armageddon.

We are at a standoff with China. It all goes back to the old saying that if you owe a bank a relatively small amount of money, then bank "owns" you. However, if you owe a bank a substantial amount of money, you "own" the bank. This is similar to our situation with China. We owe them too much money for them to become heavy-handed with us.

However, I do think that there is a silver lining. There is a way out of our current dilemma. First of all -- and I see no reason why this won't happen -- we must keep our economic efficiency high, as it has historically been. Then we must start balancing our national budget and show some fiscal restraint, both on a national level and on the individual level.

Both of these actions will put us on the right track. Good luck!


Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.


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