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.