The Dollar’s Falling! Does It Really Matter?

Most of us are aware that the U.S. dollar has been struggling lately. Evidence the fact that it has been on a steady decline compared to the euro. In fact, the dollar recently fell to yet another record low against the euro.

Besides meaning that your next trip to Europe will be more expensive, what else does this phenomenon mean? Actually, the implications are rather broad and can carry some serious consequences for America and its businesses. Let’s take a look at what’s going on with the dollar and why it has been falling of late.

First, a disclaimer — I am an investment banker and a CPA, not an economist. I don’t pretend to be an expert on economics. I do understand, however, the basic dynamics that are influencing the dollar and what the general consequences of these dynamics are.

US, World Economies Interconnected

We cannot escape the fact that the U.S. economy is, on some very significant levels, interconnected with the world economy. Why is this? Well, when one segment of the world, in this case the USA, starts buying goods from foreigners at a far greater rate than it is selling to them, we have a so-called current-account deficit.

This means that the flow of cash out of the U.S. (for the purchase of foreign goods) is greater than the flow of cash coming into our country (for the sale of our products overseas). Simply put, our imports are exceeding our exports.

You might say, so what! But, the fact is that it really does matter. Let me explain. We are not a nation of balanced budgets and net savers. Therefore, the cash for these deficits and imports has to come from somewhere. Someone has to “front” us the money to pay for our expensive appetites.

Who “fronts” us the money? The very countries from whom we are purchasing so many imports, especially China. How do China and other countries provide us with the money to finance our imports and our deficits? They do this by purchasing dollars and other U.S. assets like government bonds.

Why are they so anxious to do this? The answer is somewhat complicated but can be made simple. They do this because, traditionally, the dollar acts as the world’s reserve currency — its preferred store of value. This means that foreign countries have been willing to purchase dollars as a sort of war chest to guard against a run on their own treasuries.

The problem today is that many countries are somewhat glutted with dollars. The time will probably come (and in some cases already has) when they will realize that a continued purchase of the dollar can’t go on forever because someone (that is, some country) is going to be left holding the bag with too many dollars when the dollar falls precipitously.

Realistic Look at Consequences Needed

Bloomberg News Agency recently quoted a fund manager as he spoke of this phenomenon: “Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down.” Wow!

I don’t say that I necessarily agree with this fund manager, but we must look realistically at the consequences of foreigners supporting our dollar indefinitely without our putting our fiscal house in order.

At this point in time, many countries are willing to purchase a substantial amount of our debt and our dollars and receive a modest rate of return. This willingness would melt into reluctance if we continue to run a current-account deficit and if we continue to run-up budgetary deficits.

If reluctance morphed into a run, the scenario would not be good for America. The dollar would no longer be the de-facto reserve currency of the world. We could never abide such a phenomenon because of the obvious deleterious effects on our country, our businesses and on our standing in the world. We don’t want another country, China for example, to step in as a financial super power.

How Does China Fit into This Scenario?

This is an interesting question because the fact is that it is in China’s best interests to keep our dollar strong and not let it fall. This is because we purchase a tremendous amount of their exports.

A strong dollar means that Americans will maintain an appetite for Chinese products. Plus, a great deal of China’s state treasury is held in dollar-denominated assets.

So, in order that its exports remain competitive and that its treasury be protected, the Chinese have been reluctant, of late, to let its currency rise against the dollar. Here’s a fact: China, along with the remainder of developing Asia, has about US$1.4 trillion in reserves. These reserves are mostly denominated by dollars.

China and developing Asia have clearly shown their appetite for dollars, and their reasons are quite transparent. They want to keep their exports affordable to Americans and protect the value of their treasuries from falling.

Remember what happened in East Asia in 1997 when there was a run on their currencies. (My recollection is that the hedge-fund manager, George Soros, made quite a score by betting against East Asian currencies.) Since then, Asian countries had been keeping a vast treasury of dollars to guard against a run on their own currencies.

Today, however, these countries are keeping large dollar reserves not only to guard against runs on their currencies, but also to protect their exports by keeping them affordable — a strange twist of fate!

What Are We To Do?

The fact is that we are a very resourceful nation — a nation of dedicated and efficient workers. We have a strong economy, the strongest in the world. We do, however, have problems with our deficit and our debt that must be addressed sooner rather than later.

Also, we obviously must address our chronic current-account deficits and determine how they can be cured or, at least, mitigated.

I have no doubt that we’ll properly deal with our vulnerabilities in order to protect against a worldwide run against the dollar. We have an extremely astute chairman of the Federal Reserve in Alan Greenspan. We also have wonderful monetary and fiscal tools at our disposal that can keep us on the right course.

So, to respond to the title of my article, “The Dollar’s Falling? Does It Really Matter?,” the answer is yes, it really does matter. But, let’s keep it all in perspective. The dollar might be falling, but the sky isn’t! Good Luck!

Theodore F. di Stefano is a managing partner at Capital Source Partners and can be contacted at [email protected].

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