How Safe Are Your Dollars? (the bottom line is that these fears are exaggerated)

Chinese officials and private investors around the world have been worrying aloud about whether their dollar investments are safe. Since the Chinese government holds a large part of its $2 trillion of foreign exchange in dollars, they have good reason to focus on the future value of the greenback. And investors with smaller dollar holdings, who can shift to other currencies much more easily than the Chinese, are right to ask themselves whether they should be diversifying into non-dollar assets – or even shunning the dollar completely.

The fear about the dollar’s future is driven by several different but related concerns. Will the value of the dollar continue its long-term downward trend relative to other currencies? Will the enormous rise of United States government debt that is projected for the coming decade and beyond lead to inflation or even to default? Will the explosive growth of commercial banks’ excess reserves cause rapid inflation as the economy recovers?

But, while there is much to worry about, the bottom line is that these fears are exaggerated. Let’s start with the most likely of the negative developments: a falling exchange rate relative to other currencies. Even after the dollar’s recent rally relative to the euro, the trade-weighted value of the dollar is now 15% lower against a broad basket of major currencies than it was a decade ago, and 30% lower than it was 25 years ago.

Although occasional bouts of nervousness in global financial markets cause the dollar to rise, I expect that the dollar will continue to fall relative to the euro, the Japanese yen, and even the Chinese yuan. That decline in the dollar exchange rate is necessary to shrink the very large trade deficit that the US has with the rest of the world.

Consider what a decline of the dollar relative to the yuan would mean for the Chinese. If the Chinese now hold $1 trillion in their official portfolios, a 10% rise in the yuan-dollar exchange rate would lower the yuan value of those holdings by 10%. That is a big accounting loss, but it doesn’t change the value of the American goods or property investments in the US that the Chinese could buy with their trillion dollars.

The Chinese (or Saudis or Indians or others outside the euro zone) should, of course, be concerned about the dollar’s decline relative to the euro. After all, when that decline resumes, their dollar holdings will buy less in European markets. While it is hard to say how much the decline might be, it would not be surprising to see a fall of 20% over the next several years from the current level of about 1.4 dollars per euro.

But the big risk to any investor is the possibility that inflation will virtually annihilate a currency’s value. That happened in a number of countries in the 1970’s and 1980’s. In Mexico, for example, it took 150 pesos in 1990 to buy what one peso could buy in 1980.

That is not going to happen in the US. Large budget deficits have led to high inflation in countries that are forced to create money to finance those deficits because they cannot sell longer-term government bonds. That is not a risk for the US. The rate of inflation actually fell in the US during the early 1980’s, when the US last experienced large fiscal deficits.

Federal Reserve Chairman Ben Bernanke and his colleagues are determined to keep inflation low as the economy recovers. The Fed has explained that it will sell the large volume of mortgage securities that it now holds on its balance sheet, absorbing liquidity in the process. It will also use its new authority to pay interest on the reserves held by commercial banks at the Fed in order to prevent excessive lending. This is, of course, a formidable task that may have to be accomplished at a time when Congress opposes monetary tightening.

Looking forward, investors can protect themselves against inflation in the US by buying Treasury Inflation-Protected Securities (TIPS), which index interest and principal payments to offset the rise in the consumer price level. The current small difference between the real interest rate on such bonds (2.1% for 30-year bonds) and the nominal interest rate on conventional 30-year Treasury bonds (now 4.6%) implies that the market expects only about 2.5% inflation over the next three decades.

So the good news is that dollar investments are safe. But safe doesn’t mean the investment with the highest safe return. If the dollar is likely to fall against the euro over the next several years, investments in euro-denominated bonds issued by the German or French governments may provide higher safe returns. Even if the dollar is perfectly safe, investors are well advised to diversify their portfolios.

"So the good news is that dollar investments are safe. But safe doesn’t mean the investment with the highest safe return. If the dollar is likely to fall against the euro over the next several years, investments in euro-denominated bonds issued by the German or French governments may provide higher safe returns. Even if the dollar is perfectly safe, investors are well advised to diversify their portfolios."

Yeah. "It's different this time."

Not.

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

~~Ludwig Von Mises

Sounds nice. Even sounds logical on the face of it.

But the real numbers just don’t work out that way.

In the 80s, large deficits were “sustainable”. At that time, it was even theoretically possible to balance the budget and reduce the national debt. That is mathematically impossible now.

In the 80s, China and others did not hold enough of our debt to influence our foreign policy. They do now, and they are hinting they are willing to do so.

There a lots of other things that are seriously different than in the 80s, both here and in the rest of the world. IMO, it is poor logic to talk down our situation by making analogies to the 80s. Or any other time, for that matter. The waters we are in are very much uncharted.

The author’s credentials :

Martin Feldstein, a professor of economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.

“Martin Feldstein, a professor of economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.”

I vividly remember ALL the experts, of Feldstein’s credibility, from all sides of the political spectrum saying 2 years ago that the mortgage crisis was overblown (even though loans worth 10x the income were ROUTINELY being given to people throughout California and many other places). Fortunately, I didn’t listen to them and instead made a decent amount of money shorting financials.

Bottom line is that I don’t think that even the BRIGHTEST economists are able to comprehend some things (like a collapse of our banking system when everything, at the time, looked just fine). And saying that $1T deficits, while engaged on a negative growth economic policy (i.e., cap and trade, takeover of health care, card check, etc.) shows me that they are AGAIN clueless.

This HAS TO end with the dollar crashing in some way...we simply will not be permitted to borrow from others, at this rate (or greater), forever.

Sure your dollars will be safe.You’ll only need a wheelbarrow full to by a loaf of bread. That was the cause of Hitler’s rise to power and the eventual start of the second world war.

I just hope it doesn’t happen that way this time.

The dollar has never been safe. If an item cost $1.00 in 1913, it would require $20.00 today to buy that item. That means the 1913 dollar is now worth 5 cents. That does not compute with me, as a dollar being safe. Personal example: house purchased in 1949, $4,000. Monthly mortgage payment $40.50. My pay/week, $60.00 about $3,000/year. Salary X 1 1/3 = house cost. Today, median yearly wage is about $50,000. $50,000 X 1 1/3 = about $67,000. How many houses, that you would be happy with could you buy for $67,000? Carton of cigarettes in 1949, $1.50, today $50.00. 33 X more. How safe is the dollar? Gasoline/gallon 10 cents. Today $2.50. 25 X more. How safe is the dollar.

Ya. Back in the day he might have been a powerhouse. But now he's just some 70-year old Harvard professor who helped educate many of the people who created our current problem.

So, color me unimpressed by his credentials.

And "As a member of the board of AIG Financial Products, Feldstein was one of those who had oversight of the division of the international insurer that contributed to the company's crisis in September, 2008."

I'll take someone who's a little more in touch with reality.

Spoken like a true elitist who has a vault full of gold and silver and his own private security detail. The dollar is becoming toilet paper money. Everyone, when you look inside, knows this. That’s why the majority of the people believe that government is the biggest threat we face. Get ready for the EPS-electronic police state. Its coming. Buy gold, buy silver, buy guns and buy ammo and don’t wait very long. The window of opportunity is rapidly closing.

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