December 6, 2004

In order to address all of these questions it might be useful to ask a slightly different question:  why is the dollar falling?  Like most things in economics, there is not one single factor.  Part of the story is the American low savings rate, part of it is our Federal Government budget deficit, and part of it is a legacy from years gone by.

Let’s start with the last one first:  history.  Ever since the Great Depression, the U.S. economy has been based on the Keynesian notion that spending is good and savings is bad.  Even though we started to reverse many of these Keynesian policies way back in the 1980’s, the underlying structure is still very much still with us…just look at the tax code.  So we Americans spend a lot and save very little. 

Just as bad, a number of economies around the world are built on the Mercantilist notion that exports are good; imports and domestic spending are bad.  Even though Mercantilism has been shown to be a completely discredited theory (it helped trigger the Great Depression), it is still practiced by a lot of governments today.

So what we have is a consuming, non-saving America and an exporting, non-consuming rest of the world (I exaggerate only slightly).  Add to this wacky imbalance a “strong dollar” policy put forward by the Clinton Administration and followed (initially) by the current Bush Administration and you have the making of a HUGE American current account deficit. (Current account deficits mean you import more stuff than you export)

When a country imports more than it exports its currency should depreciate…unless someone or something intervenes.  And intervene they have!  For years…propping up the dollar in the FX market…so the current account deficit grew and grew.  One of the natural adjustments to a current account deficit is for the currency to depreciate…and that is what is happening now to the dollar.

How long will all of this last?  It is hard to say…some say another 10%...or maybe governments (or central banks) will intervene again.  This gets us back to those Mercantilist foreign governments.  They have a real problem with the falling dollar.  As the dollar drops it makes their exports in the U.S. more expensive.  This isn’t really that big of a deal unless you have a Mercantilist economy where the entire structure of the economy is based on exports! 

The falling dollar is also a concern for Europeans.  The Euro Zone economies are finally showing some signs of life, thanks to their exports to (an even faster growing) America.  Until, that is, the dollar starts to fall.  Remember a falling dollar means those European made goods will be more expensive in the U.S.  As the dollar falls, so does the hopes for a European economic expansion.

Another group that is getting worried about the fall in the dollar are all of those “insightful” American managers who thought a surefire, easy, way to profitability was through finding “low cost production centers” around the world.  As economists have often said “management by slogan is usually a recipe for disaster.”  The “low cost production centers” will turn out to be HIGH COST production centers if the dollar continues to fall.  This will especially be true when (not if) the Chinese Yuan floats against the dollar.

This then gets us to the worry over inflation.  As the dollar falls imports in the U.S. get more expensive.  As this occurs the price of domestic made competitors will also be pushed upward.  All of this upward pressure on prices, in turn, worries the Fed.  The Fed will probably raise interest rates as a pre-emptive strike against inflation.  This will, in turn, help to stop the fall of the dollar.

However…these changes in monetary policy still do NOT address the larger underlying causes of the problem:  low U.S. savings rate, very dangerous and destructive Mercantilist policies around the world, and the need to restructure many of the European economies.  There key issues are still not being discussed.  That is a shame.

Regards,