The dollar has been in sharp decline in recent months -- the greenback is now worth less than the Canadian dollar, and against the euro, it has lost 60 percent of its value since 2001. A doomsday scenario has the U.S. economy spinning out of control: the dollar plunges, financial markets crash, and the Federal Reserve is powerless to halt the collapse since cutting interest rates would send the dollar down even further. But W. P. Carey experts Herbert Kaufman and Kent Hill believe that concerns of a dollar-triggered financial crisis are overblown."/> The dollar: Down but not out

The dollar: Down but not out

November 21, 2007

The dollar has been in sharp decline in recent months: the greenback is now worth less than the Canadian dollar, and against the euro, it has lost 60 percent of its value since 2001. Hip hop artist Jay-Z was seen in a recent video flashing 500-euro notes -- not $100 bills.

 

A doomsday scenario has the U.S. economy spinning out of control: the dollar plunges, financial markets crash, and the Federal Reserve is powerless to halt the collapse since cutting interest rates would send the dollar down even further. Inflicting additional harm would be ever-rising oil and food prices.

 

But two experts at the W. P. Carey School of Business believe that concerns of a dollar-triggered financial crisis are overblown.

 

"I think it's a little bit dramatic and melodramatic," says Herbert Kaufman, professor of finance. While the potential for trouble exists, he says, the dollar's problems should not have widespread consequences. "I believe our economy can absorb it. The Federal Reserve can take appropriate action if necessary," he says.

 

Economics Professor Kent Hill contends that the dollar's woes are really a "sideshow" to larger matters of the economy, such as the country's savings rate, Social Security and Medicare liabilities, and government fiscal policy.

 

"While I am concerned, these things are not going to play out overnight," says Hill. "I view the downside of all of this as a nibbling away at our future rather than a cataclysmic fall."

 

Underlying causes

 

In assessing the impact of the dollar's fall, it is important to understand why it is happening, they say. Hill says that the country's ballooning deficits -- in both budgets and current accounts -- prompt currency traders to place less value on the dollar.

 

"The dollar is very sensitive to financial flows. When those change in magnitude or direction, it's felt immediately by the dollar," Hill says.

 

According to Kaufman, the dollar's weakness springs from a weakness in the national economy.

"Somebody once said the foreign exchange value of a currency is a bet on the country. I think there is a bet that the economy is not quite as robust as it was," he says.

 

It is no coincidence that the dollar's slide occurred about the same time that the woes of the subprime mortgage industry became widely known, according to Kaufman. "The weaknesses we have in the credit markets, in which the catalyst has been the subprime mortgage crisis, is of great concern not only to foreigners but to U.S. citizens as well," he says. 

 

The China problem

 

Worries about the dollar these days usually start with China and its trade and investment relations with the United States. The Chinese hold over a trillion dollars worth of dollar-denominated assets. China has given signals that it is looking to diversify out of dollars, and the possibility looms that the Chinese could unload its dollars and send the currency into a free fall. Kaufman says this scenario, while frightening to consider, is highly unlikely.

 

"The problem that they would have is you can't just dump this all at once at a given market price," he says. Unloading a trillion dollars in assets takes time, and prices would start to fall at the first sign of a sell-off. By the time it was over, the Chinese would have paid a high cost, according to Kaufman. "They would have to inflict fairly substantial losses upon themselves in order get out of a small portion of their dollar position," he says.

 

Hill also sees no indications that the Chinese are preparing to unload dollars in a hurry. "It may not be that the Chinese are getting nervous about the United States. It may be that they just want to diversify the foreign assets they are holding," he says.

 

The rising price of oil also has contributed to concerns about the dollar. Oil is traded in dollars, and there are concerns that the oil exporting countries will revise this by pricing using a market basket of currencies, further increasing the price of oil in dollars. "The increase in oil prices for Europe hasn't been what it is for the United States, because of the decline in the dollar," says Kaufman.

 

Hill believes it is important to take a long view of oil prices. "If you just look over the last three years rather than the last month, oil prices have gone up for everybody," he says. "The currency is a sideshow again. It has to do with limited supply bumping up against very strong demand." 

 

Market corrections and desert real estate

 

The fall in the dollar is not all bad, according to Kaufman and Hill. Currency markets have built-in self-correcting tendencies, they say. A falling dollar makes American goods cheaper for foreigners, while foreign goods become more expensive for Americans. U.S. exporters should benefit, while American consumers will tend to shun imported goods and purchase things produced here.

 

"Theoretically what it should do is lead to a reduction in the deficit in our balance of trade and balance on current account, which have been at enormous levels," Kaufman says.

 

Adds Hill, "What the weaker dollar does is help the U.S. economy to get stabilized."

 

In any event, there is not a great deal the U.S. government or the Federal Reserve can do about the dollar anyway, they say. The Federal Reserve could boost the dollar by raising interest rates, but the cost would be high. "Given the credit crisis we're facing domestically and internationally, I don't have the sense that they would try to prop up the dollar in that way," Kaufman says.

 

Hill says that the Federal Reserve does not really care a great deal about fluctuations in the dollar unless the currency movements are part of a larger crisis. "Typically the Federal Reserve is much more focused on whether we're entering a recession or not, or whether there's a crisis in our financial system," he says.

 

The U.S. Treasury can influence the dollar's value by instructing the Federal Reserve to buy or sell dollars on the open market. The Treasury did this in 1980s, when the dollar reached record levels. But the dollar's fall so far appears not to have approached the point where the Treasury would be moved to act, according to the experts.

 

"I don't anticipate it," Kaufman says. "It's not been a part of our policy for years, and I don't see it happening."

 

A less valuable dollar does have its benefits, and Kaufman has noticed some of them in Arizona, where the real estate market has been in a slump of late.

 

"There are a lot of Canadians coming down and buying property in Arizona," he says. "That's how it's supposed to work. One currency appreciates against another, and that stimulates the sale of assets or goods in the other currency." 

 

Bottom Line:

 

  • The value of a currency is linked to the strength of a nation's economy. The decline in the dollar in recent months is due, at least in part, to the country's trade imbalance, growing budget deficits, and weakness in U.S. credit markets.
  • The Chinese hold over a trillion dollars in dollar-denominated assets, and a dollar sell-off by China would be a disaster for the United States. While China may be looking to diversify its holdings, it would not be in either country's interest for China to abruptly unload its dollars.
  • Recent oil price increases have hit the United States hard, in part because oil is traded in dollars. But the currency's contribution to the pain U.S. consumers are feeling at the pump is relatively small. High oil prices are mainly the result of strong global demand and limited supplies.
  • Currency markets tend to be self-correcting. When the dollar falls, U.S. goods become cheaper to foreigners, and foreign goods become more expensive for Americans. U.S. industries should get a boost, which eventually could bring a stronger dollar.