Beware the Weakening Dollar

SINCE THE FED CUT interest rates by 50 basis points last week, the U.S. dollar has fallen by 1.7% against the rest of the world's major currencies. That may not sound like much, but it's actually a big move in the context of world currency markets. And it's especially notable because it takes the US dollar to a new all-time historic low.

Should anyone be surprised? The Fed's interest rate move was larger than expected, but its effect on the dollar could easily have been forecasted (in fact, I did, repeatedly, in this column). In essence, the Fed's move put more money into circulation to prop up what the central bank expects will be a weakening economy. When the Fed prints more dollars, then dollars become less scarce. So the price of dollars falls, just as the price of apples falls if a farmer produces a lot more apples and apples become less scarce. It's pretty basic economic logic.

And it's also basic logic that when the value of the dollar falls, the price of everything in the world — the dollar price, that is — tends to rise. So we shouldn't be surprised to see the price of basic world commodities like gold and oil make new highs after the Fed announcement, just as the dollar made new lows. Over time, all the prices — in dollars — for all the world's goods and services will make similar adjustments.

Yet we often hear market commentators saying it's good for the US economy if the dollar falls. The story goes that this lowers the price of US goods and services on world markets, and makes them more attractive to foreign buyers.

But let's check that proposition against simple logic. Let's say the dollar drops by 10%, so foreigners want to buy more US wheat because it seems so cheap. Farmers will sell a larger quantity of wheat and take in a larger quantity of dollars. But each one of those dollars will be worth less than it used to be — the dollar price of oil and everything else the farmer buys has gone up from his perspective. In the end, has anything really changed?

If you are a saver, you will be a loser. When the value of the dollar falls, the value of your savings falls, too. It's that simple. But suppose you are a borrower? Then, when the value of the dollar falls, the value of the debt you must eventually repay falls, too.

So it's not "good for the economy" when the dollar falls. Some people and some industries may end up winning more than they lose. But overall, the economy will suffer from all the costs and dislocations that result from suddenly having the value of the currency in our pockets and in our bank accounts arbitrarily changed.

Yet our government is doing everything it can to make the dollar fall. The Fed, which plays the largest role in determining the dollar's value, has made it clear that nothing is more important than bailing out the housing industry from its subprime lending excesses — and if that means flooding the economy with dollars, and driving the value of the dollar lower and lower, then so be it.

Congress and the White House are, in their own way, making a similar mistake. By brow-beating China to raise the official exchange rate of the Chinese currency, the yuan, they are implicitly saying that the value of the dollar should fall.

But that wouldn't really accomplish anything. If the value of the yuan were to rise, then the price (in yuan) of everything in China would fall. It would be deflation — the opposite of the inflation we will experience in the US because the dollar is falling. So once it all settled out, our dollars would still buy the same amount of Chinese goods that they do today. We can't escape the reality that people in China are simply willing to work for less and sell for less, so their goods and services are a bargain on world markets. It has nothing to do with their currency.

In worrying about a weak dollar, it may seem on the surface that I'm in the same camp as Warren Buffett and others who have warned that the US economy is an over-indebted time-bomb, and that the dollar will eventually collapse because of our profligacy. That's not where I'm coming from. I think Buffett's analysis is utterly wrong. The value of the dollar has almost nothing to do with the strength of the economy.

How come the dollar surged while the economy was weak in 2001 and 2002? How come the dollar fell as the economy strengthened from 2003 to the present? Clearly, there is no relation between economic strength and the value of a currency.

No, it's all about the Fed. It's all about how many dollar bills they churn out of their printing presses, and how many helicopters they use to rain those bills down upon our heads. That's all that matters.

So what do we do now as investors, given that the Fed is gearing up the printing presses and revving up the helicopters?

Again, simple logic. Buy the stocks that are the most immediate and obvious beneficiaries of inflation — energy and basic materials. Those two sectors have been the best-performing since the stock market bottom on Aug. 15, and I think they will continue to be. Export-driven industrial and technology companies should be winners, too, at least in the short run.

But in the end, let's not have a lot of illusions about this. Inflation is not good, and inflation is what we are going to get here. There will be winners and losers, but ultimately we'll all be losers. Someday the Fed will have to jack up interest rates sky-high to stop the inflation it's now causing.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors.

"What we are talking about is a financial chess game, that always results in the US returning to the “runner” of the board.

So, "we will always win, because, we are Americans!"

Pride goeth before the fall.

Previously, our allies always stepped in to protect the dollar at key exchange rates, afraid of the global system losing its balance. The yen at 110, the Euro at 140 etc. That is, they would lower interest rates to protect the dollar status quo.

This is not happening this time. The world sees the dollar as doomed this time, and they don't want to ride it down. The Saudis are not dropping interest rates as they have previously, which means they are dumping their dollar peg. The Chinese are staying away from the T window. This is not just another swing in the old cycle. This is the end of the dollar's world reserve status. We are not going to just "run the board" again because we are America, and we always win.

I enjoy your posts, you really understand things imo.

A point I’d like to add to the discussion is I notice many learned Americans, major journalists, economists, experienced bloggers and forum users.. are blissfully ignorant of Europe’s rising economic strength. I notice some making increasingly elaborate conspiracy theories for why the Euro keeps rising, and why its about to fall back down dramatically.

It seems many are living in the 1990’s.. when economic growth was being driven by IT. And America’s best in the world venture capital and small business system was growing by leaps and bounds, while Europe was stalled out.

What they missed was ‘the transition’.. into this decade when IT started really increasing the productivity of big operations. The biggest sign I know of, the French firm Alcatel bought Lucent one of the stars of the tech boom. Europe was never really great at making small business, but they’ve always been good at running large national champion companies. No one I know of thinks that Cadillac or Lincoln are remotely close to BMW or Mercedes in technology, sales or profit. Europe’s big corporations are growing powerfully and their tech portfolio is growing.

Then there is Euroland’s unseen economic power to consumers. Like European engineering firms, glass makers, advanced metal producers.

I liked your statement ‘we will always win, because, we are Americans!” Its true its like we will always win because we spend slightly less on government then them. As if things like how many of our young are becoming engineers doesn’t make any difference to national wealth. Or how well ran our big companies are being ran, as opposed to ceo’s looting them for all their worth.

A point I’d like to add to the discussion is I notice many learned Americans, major journalists, economists, experienced bloggers and forum users.. are blissfully ignorant of Europe’s rising economic strength

Really? Based on what data? Their GDP growth has been below ours, their inflation rate has been higher, their unemployment #s are far worse. Some of Scandanavia (not in the Eurozone) is doing well because of oil exports and some of the eastern european countries are doing well, but most of old Europe is doing far worse than we are AND their central bank lending rates are below ours. Our currency is mainly down vs just European currencies predominantly and from the best I can tell no good reason. M0 & M1 in Euros is going up, while M0 & M1 in USD is actually dropping. Our export #s are soaring (up 49% in 4 years) while Europe is really struggling.

Also, wouldn’t gold be better than Euros, in case the European Union gets in trouble?

I'm not an expert but;

Right now I'm reluctant to put more money into gold while it's so high.

It's nearly double the price I paid just a few years ago.

However with the dollar weakening it seems the trend around the world is to move more into euros as a reserve currency.

“I’m not an expert but;

Right now I’m reluctant to put more money into gold while it’s so high.

It’s nearly double the price I paid just a few years ago.

However with the dollar weakening it seems the trend around the world is to move more into euros as a reserve currency.”

Thanks for your input. I purchased some gold when it was down, and will probably just buy a little more.

I figure IF something happens, at least I’ll have grocery money, etc., and IF the worst happens, the gold we have will be worth a LOT.

Sorry was going to get back to you a couple days ago then got sidetracked. I agree each year the gdp numbers show us growing around 3% and the EU countries growing maybe 1-2%. I’ve been watching gdp around the world since I started websurfing in about 1996 or 97. I remember when China was around 3,500 in ppp and I was calculating what it could be in 10 and 20 years at the rate of growth!

The thing is they seem to calculate the numbers in relation to that specific nation. So if they are calculating Sweden’s growth for 2005, they only take into account basically inflation in Sweden and the internal gdp growth.

But then if the currency moved quite a bit, and they translate it into Dollars, from Euros or Krone or whatever the Swedes use.. that number changes it in relation.

49% rise in exports for us is a great sign. And the falling dollar is starting to make some of our really big big industries competitive again. And thats what I’m talking about, some little tech company isn’t going to drive national wealth.. . A company like GE growing powerfully is going to drive national wealth.

Here is Germany’s exports since 2000. Germany I believe is their powerhouse right now.. And these numbers are inflation adjusted to 2000.

2006: 1031.552000000000000
2005: 916.867000000000000
2004: 857.872000000000000
2003: 782.493000000000000
2002: 764.182000000000000
2001: 732.722000000000000
2000: 688.390000000000000

US exports since 2000.. not adjusted for inflation.

2000: 780,418,627,647
2001: 731,025,906,239
2002: 692,999,529,459 (dollar too high)
2003: 723,743,176,992
2004: 817,935,848,814 (dollar lower propelling exports)
2005: 904,379,818,000
2006: 1,037,142,973,000 (12% growth in one year.. cheers!)

Since 2002 US exports have risen 49%. But since 2000 they have risen 33%. German exports have risen 49% since 2000.

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