Since 2001 the dollar has been in steady decline. Against the £ the dollar has fallen from a low of £1 = $1.45 to close to the £1 = $2 mark. Against the Euro the $ has also depreciated from 0.85 to the present level of 1 Euro to $1.35.

From several perspectives the fall in the value of the dollar appears to be following basic economic fundamentals and whilst these imbalance continue the dollar may continue to fall.

Firstly the US current account deficit is remaining at record levels. The exact amount of debt with the rest of the world is predicted to be around $710 billion for 2006 [1]

Basically this means America is importing more than it is exporting, causing an outflow of money. In recent years this huge level of debt has been bought by countries like Asia who have been happy to buy into the dollar for its perceived status as a “stable and secure” currency. However there is increasing evidence Asian bankers are no longer so confident in the American economy. Thus they are seeking to divest from the dollar and reduce their dollar holdings. As this occurs the dollar will have to fall as there is insufficient buyers of American debt.[2]

Secondly the future for economic growth is no longer looking so positive. Growth forecasts have recently been downgraded. The OECD has downgraded is growth forecasts for the US economy from 3.6% to 2.4%. Pessimists such as Nouriel Roubini, of Roubini Global Economics [2] are predicting a recession in the US by the middle of 2007. An important factor in declining growth forecasts is the falling US consumer confidence.

Related to this is a signal that the previous ebullient housing market may have at last turned the corner. Whilst new house prices continue to rise. The median price of old houses have fallen by 3.5% since last year. Whilst a fall of 3.5% may not sound that much, it is the biggest on record. Also rising house prices have been a key factor in maintaining consumer spending in recent years. The level of personal debt amongst US consumers is at another all time high. The ratio of consumer debt to disposable income has risen from 62% in 1980 to 127% in 2005 [3]

Thus a fall in house prices will have a powerful knock on effect on the rest of the US economy as consumers struggle to refinance and meet levels of debt. Another consequence of this high level of consumer debt is that the US economy will be particularly sensitive to any rise in interest rates. Higher interest rates would be one solution to a falling currency and may be necessary to attract investors to finance America’s trade deficit. Although the prospect of the Fed raising interest rates is remote at the moment. Continued falls in American dollars would cause a rise in the long term interest rates on American secutities.

However some economists argue that prospects for the dollar may not be as bad as some predict. Firstly as Anatole Kaletsky argues [4] in an era of globalisation and deregulated financial markets, trade deficits are not as difficult to finance as they used to be. Empirical evidence suggests that trade deficits are very unreliable as a guide to exchange rate movements. Firstly one of the few countries with a current account surplus is Japan. Their current account surplus has been growing and yet the Yen is one of the few currencies to have fallen against the dollar. [4]

Secondly although American growth is slowing at the moment it is not doing much worse than the EU and Japan economies. The gap in interest rates between the 2 economic areas is still only about 2%. If there are good reasons for the dollars weakness there are less good reasons for the strength of the EURO. Also some American economists such as Ben Bernanke of the Federal reserve remain optimistic about the state of the US economy arguing growth is only marginally below trend rate.

However it is important not to underestimate the importance of general market sentiment regarding the American economy. Political problems such as in Iraq have to an extent undermined America’s standing as a leader of the World in both an economic and political sense. For 50 years America has been the undisputed global economic superpower, but slowly perceptions are changing that the era of the dollar may becoming to an end. As people switch out of dollars it could create a powerful multiplier effect as investment bankers are reluctant to hold onto their dollar assets.

America to a large extent can’t avoid a period of adjustment as it seeks to deal with its triple deficits, trade deficits with the rest of the world, consumer debt, and US government debt. Whether the period of adjustment is gradual or painful will depend upon 2 things. Firstly how significant will be the fall in US house prices and consequent fall in consumer confidence. Secondly it will depend on the attitude of Asian bankers, in particular the Chinese. Since they hold so many $ assets they may try to manage a gradual devaluation, a continuation of the past 5 years. However if the dollar does lose its status as the reserve currency of the world, there could be a growing stampede as America’s creditors seek to cash in their cheques. This would exacerbate the fall of the dollar, causing real economic hardship for America and the rest of the world.

The only thing for sure is that European consumers are likely to be get some real bargains from shopping in America for the considerable future.

References

[1] http://www.cbsnews.com/stories/2006/01/12/business/main1203762.shtml

[2] http://www.economist.com/finance/displaystory.cfm?story_id=8361260

[3] Available at http://www.federalreserve.gov/releases/Z1/Current/

[4] http://www.timesonline.co.uk/article/0,,630-2485597.html - Demise of Dollar greatly exaggerated

Richard is an economics teacher in Oxford. Richard has written many articles on economics and the UK housing market. He edits a website on Economics and updates a blog about economics and mortgages

Forex News Day Trading Signal - 06/05/08 Part 2

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As we enter 2009, many if not most agree that the US economy is struggling, and that these struggles will continue. An increasing number have been making comparisons to the Great Depression. With that in mind, let’s compare and contrast the situations:

Similarities

1. Both were preceded by an extensive period of credit-fueled bubbles. Before there was the Great Depression there was the Roaring ’20s; likewise, before Depression 2.0 were the Greenspan NASDAQ and housing bubbles. Consistent with Austrian business cycle theory, the end result of a credit-fueled bubble will be a corrective recession that purges out the malinvestments resulting from an excessive expansion of the money supply.

2. Both were marked by government interventionist policies designed to prevent falling asset prices. For instance, bans on short selling occurred in 2008 and at the beginning of the Great Depression. Likewise, stimulus packages were the prescribed remedy at the onset of the Great Depression, and are in vogue once again now. It’s worth noting they were unsuccessful back then, and don’t appear to be succeeding now.

Differences

1. There is a lack of a gold standard, which serves as a restriction to how much the money supply can be expanded. The dollar was devalued relative to gold during the Great Depression, so there were attempts to circumvent restrictions on the money supply, but ultimately the gold standard was not fully abolished until 1971, and so the Federal Reserve was a bit more restricted in how much money it could create. This restriction does not exist today.

2. America was not as debt-ridden during the Great Depression as it is today. Credit cards are a rather new creation, and the national debt and deficit spending were significantly lower.

3. America’s debt is owned largely by foreigners. This introduces the possibility of economic warfare; foreign debt owners can devalue the dollar by selling Treasury bonds as well dollar reserves.

4. All major currencies are fiat currencies, and the US dollar is the world’s reserve currency. This helps the United States in a way, as central banks have been inflating their money supply along with the US dollar to maintain parity of sorts. In this way, the US gets to export its inflation.

Conclusions

1. Because of the similarities, it is reasonable to expect asset prices to continue falling in real value. It is easiest to define “real value” as the price in gold; in other words, assets will fall relative to the price of gold.

2. Because of the differences, currency devaluation as seen in Argentina’s depression in 2001 and Iceland’s depression in 2008, is much more likely. Those who argue for deflation and a scenario similar to Japan are not considering that the Federal Reserve under Bernanke is willing to use unorthodox measures to inflate; Japan was more cautious, and did not heed the recommendation of economists like Paul Krugman, who had called for the Bank of Japan to fully monetize Japan’s budget deficit by simply creating more money. As there are no restrictions on the Federal Reserve to expand the money supply as it pleases, currency devaluation is more feasible. Moreover, unlike Japan and like Argentina and Iceland, the US is a debtor nation — not a lender. This increases the likelihood of a run on the currency, which will result in significant currency devaluation.

3. Because of the US dollar’s role as world reserve currency, other economies may try to devalue their currency along with the US dollar to avoid the pain and chaos of decoupling. This would result in the value of all fiat currencies falling.

4. Depressions that are purely deflationary, like Japan and the Great Depression, last significantly longer and can be characterized by reversals that last for years. Roger Nusbaum noted this in his 2009 forecast, in which he expects a rally — offering a comparison to the significant rallies that occurred during the ’30s during the US’ Great Depression. Inflationary depressions, though, have a much sharper and harder fall, and thus do not have genuine rallies until currency stability is restored.

5. While zero percent interest rates and quantitative easing are the tools currently being utilized, should currency devaluation begin to be an issue, raising interest rates will be the most likely and most effective way of preserving the US dollar’s value. Paul Volcker’s policies during the late ’70s and early ’80s are a historical precedent in this matter, and interestingly enough, Volcker has returned as an economic advisor. Should interest rates rise, this would likely send stocks falling.

6. Should foreign currencies devalue along side with the US dollar, gold and silver should rise. Should foreign currencies decouple, the US dollar may fall relative to them.

Disclosure: Long gold and silver.

Simit Patel is a currency trader and contributing analyst at InformedTrades.com, a site offering free courses to help individuals learn to trade the world’s financial markets. You can visit Simit’s blog on InformedTrades by clicking here.

FOREX Video | Oil Swing Trade Review | June 4th, 2008

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