From the January 2008 issue of Research Magazine • Subscribe!

Currency Collapse

The past year was marked by such a dramatic decline of the dollar that it can almost be described as a collapse. The once mighty greenback set record lows against the Canadian dollar, the currency of America's largest trading partner. For the first time in over a quarter of a century, the UK pound was worth more than two bucks, making American visitors to London feel like very poor cousins.

The slide of the dollar against the euro in recent years has been especially worrisome. When the single currency was introduced in 1999, it was derided by some economists as an unviable mongrel cooked up in the minds of Brussels bureaucrats. In the early years of the decade the euro was worth as low as 80 American cents. But by late 2007 it had rocketed close to $1.50, a depreciation of almost 50 percent for the greenback.

The dollar has weakened across the board, losing ground to currencies in Asia, Eastern Europe and Latin America. Its real effective exchange rate, the broadest measure of a currency's value, has fallen to the lowest level since the late 1970s.

Benign WeaknessAfter I wrote recently bemoaning this situation, I got an irate phone call from a reader. How could I not understand that a weak dollar is a godsend for the U.S. economy? Our trade gap will narrow as U.S. exports are spurred by lower prices when translated into foreign currencies. U.S. multinationals, which are already seeing healthy profits from their overseas operations, will see further benefits as their foreign earnings are translated into cheaper dollars. This in turn should attract foreign investors to Wall Street -- especially since share prices will seem cheaper from their point of view. Besides, foreigners will buy up American real estate, boosting the sagging market.

Perhaps Americans do feel like paupers abroad, but who cares? More Americans will stay at home, whereas foreign tourists will flock to the United States, benefiting Disney, Las Vegas casinos, various U.S. hotel chains and other companies in the leisure and tourism industry.

Practical TestsHe pretty much summed up the arguments hailing the weak dollar. Already there seems to be considerable evidence backing this reasoning. New York City has been adding hotel rooms by the thousands, with some 100 new hotels under development, but occupancy rates have remained very high. The average daily rate at a New York hotel rose by 12.2 percent in the first half of the year, to $269.

Meanwhile, the third quarter U.S. merchandise trade deficit shrank by a remarkable $36 billion from the previous quarter, spurring slackening economic growth.

However, devaluations do not provide a lasting solution. They tend to work over the short term, whereas longer term economies tend to adjust to weaker currencies. The IMF found this out the hard way in the 1970s and 1980s, when its standard prescription for developing economies was to devalue the domestic currency and to export out of trouble. Even though it also required its clients to implement fiscal austerity, the Fund found that the troubled economies would be in the same position in just a few years -- in part because softer currencies imported inflation.

After going through each devaluation-inflation cycle, the clients found themselves not in the same spot but progressively worse off. As monetarist critics of the IMF pointed out, the weakening of the currency undermined confidence in the country's money. It was only under conditions of strong and appreciating currencies in the current decade that Latin America, Asia and Eastern Europe were able to break the vicious cycle and restore financial and economic stability.

The same is true of the United States. The nadir of American economic power during the 1970s was associated with a long period of an exceptionally weak currency. Certainly U.S. manufacturing industries -- which at the time had a larger weighting in GDP than they do now -- were never spurred by the weakness of the dollar. Nor were investors, foreign or domestic, attracted to Wall Street. Share prices remained flat for most of the decade.

The economic recovery commenced in the 1980s and it was preceded by a stronger dollar, which rose despite a deep economic downturn early in the decade. The greenback became so attractive to foreign investors that by 1985 the group of five leading industrial nations had to conclude the Plaza Accord to limit its ascent.

Similarly, the rapid growth in the second half of the 1990s was accompanied by a rising dollar.

Sign of DistrustAs could be expected, imported inflation is already rearing its ugly head. In the third quarter, the mirror image of rising exports was rising import prices, which jumped 9.6 percent in October from the previous year. For the first time since the late 1970s, a major price index is now nearing double digits.

But inflation is only the tip of the iceberg. A weaker dollar reduces the overall value of the U.S. economy and therefore cuts into America's influence around the world. And there is absolutely nothing good, either from the psychological or economic point of view, that Americans feel poorer than Asians or Europeans. Nor is it such a great thing that our real estate, businesses and other assets are being offered to foreigners at bargain-basement prices. It may be circular reasoning, but it is nonetheless true that the reason why the dollar is so weak is that there aren't enough U.S. assets that foreigners wish to buy relative to their holdings of U.S. dollars.

Besides, the dollar is no ordinary currency. It is the lynchpin of the international financial system. As a reserve currency, it backs the value of other currencies, including the currently strong euro and pound. If it weakens, all money is devalued in terms of the goods and services it can buy -- which of course is the basic definition of inflation. It may be another form of circular reasoning, but a falling dollar has gone hand in hand with rising oil prices, with the two trends reinforcing one another.

The United States is also the guarantor of the existing world economic order. More than just U.S. economic weakness, a falling dollar is a vote of no-confidence in Washington's political leadership. It is no surprise, then, that gold prices rose above $800 per ounce in the second half of 2007. While the greenback is a safe haven in the existing system, gold has always been a timeless safe haven, recognized as a store of value in all historic periods and most cultures. Gold provides a measure of protection against a systemic collapse -- which is the reason why gold also traded at high levels during the 1970s, when in the aftermath of the Vietnam War America briefly lost its ability to lead.

Playing with MoneyThe dollar may yet recover, and economists and monetary authorities should be working towards its resurgence, not rejoice in its weakness.

In the early 1970s, notorious Brazilian economy minister Antonio Delfim Neto declared that inflation didn't really matter as long as wages and bank accounts were fully indexed. Then it would be as though there were zero inflation -- everyone got fully compensated.

This great idea seemed to work fine in theory, but in practice it proved a different matter -- which monetarist economists could have easily predicted. Inflation continued to accelerate, until Brazil began to suffer periods of hyperinflation, defined as price increases of 50 percent or more per month. The Brazilian currency was destroyed and was replaced by a succession of cruzeiros, cruzados and, finally, the real.

When something like this happens in Brazil, Argentina or even the U.K., which dallied with devaluations in the 1970s -- only domestic businesses and consumers suffer, along with foreign investors foolish enough to put their money into an economy which doesn't respect its own currency. When the U.S. dollar begins to wobble, the entire world is suddenly at risk.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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