Is the weak US dollar bad for everyone?

Saturday July 4, 2009

The dollar has been consistently weak throughout 2007 and 2008.  The decline came shortly before the credit crunch started to hit in America and the dollar has not recovered.

Although it is easy to look back and to assert that the dollar weakened as a result of the credit crunch, this is not in fact the case.  The dollar was weak prior to this, indeed the fact that it was weak when the credit crunch hit, did not actually help to ease the crisis that hit US markets.

Its decline started as early as 2004.  The US was faced with a massive trade deficit and many financiers and economists felt that the best way to deal with this, was to allow the dollar to become weaker.  The weaker it became, the more trade would be able to recover on overseas markets (or so the reasoning went).

In addition, the euro was strong and the fact that it was kept strong by the European Central bank, did little to help the dollar.  But the situation seemed to be in control and the weak dollar was not a major cause for concern.

Some people (particularly those outside the US) felt and continue to feel that the US dollar being weak is not necessarily a bad thing since the US dollar has long held a status of dominance in the world’s financial markets.  As a result it has been exceptionally strong and indeed is the world’s most popular reserve currency.  After all, countries that are not so rich as America try to get their hands on the dollar because it is a surety and if you have dollars, well things can’t go that wrong can they?

The dollar is also the unit of measuring the price of some items, particularly gasoline, in the form of petrol as well as gold.

So in terms of influence the dollar is influential and indeed, it has been influential for some time.  This has led to the dollar and its fortunes being keenly watched by people all over the globe and since it suffered a period of decline, many people are now wondering whether the dollar will ever recover fully and whether it will reach the giddy heights that it did in the 20th Century.

The US dollar and the Euro

The European Union and its Central Bank are keen to see a stable and powerful euro and indeed this has been achieved.  The euro is now exceptionally strong and it is used as the standard of currency in 15 countries.

This makes the economic strength of the euro very great indeed.  It will also become more powerful as time goes on.  Countries that have joined the European Union since 2004 will have to adopt the euro as their legal currency and it will then become even more widely used throughout the continent of Europe.

Any country wishing to join the euro has to show that it has, to a large extent, achieved economic stability and that their economy isn’t suddenly going to go into meltdown.

This is a very clever move on behalf of the EU.  It has, through introducing this criteria, ensured that the basis for the economy of the European Union as a whole is stable and that it will not be weakened by new countries joining.  In short, it is operating a policy of self-protection, ensuring that it is strong enough to weather economic declines and any booms or busts that may take place.  It has strapped on its safety belt and knows that there may be bumpy times ahead, but it is keen to take the ride anyway.

It has consistently kept the euro strong, so that the euro is now the world’s second most popular reserve currency and countries from all over the world are now becoming desperate to get their hands on the euro, regarding it as a stable unit of currency that will be resilient and will make it through when indeed the dollar may not.

If we contrast this economic thinking with the US, it soon becomes apparent just who is really in control.  The US has, over the last few years, seen a huge rise in government spending.  Yet this spending has been funded from nothing, in other words, the government have actually overspent.  Some people have been predicting since 2006, that a devaluation of the dollar is actually inevitable, due to the fact that the trade deficit situation is so bad and the government have just kept on spending.

In addition, consumer spending and the credit crunch have been two major factors that have contributed to problems in the US economy, yet lessons do not seem to have been learnt.

Credit and consumer spending

Thirty years ago people had a very different approach to money.  People worked, they earned money and then they spent that money and saved a little to put by for when they had no money, or just needed something out of the ordinary.

In other words people spent only money that they had.  There was little concept of credit, only cash that had been earned or saved.  Occasionally people may have bought something using a hire agreement, but this was not considered to be always a good thing.  The whole ethos of the era was to buy what you could afford, spend wisely and then save for a rainy day.

My, how times have changed.  The whole way of thinking about spending and saving has changed dramatically and nowhere more so than in the US.  Credit has become the way of life for a great many people.  You don’t have the money?  Well that’s ok, because you can just put it on your credit card and then pay it off when you can.

Some economists love the concept of credit, because it allows the injection of ‘liquid’ money into the economy.  If we earn our pay checks, spend wisely on what we need and then put a little away for a rainy day, then the whole economy can be a little slow and money just doesn’t flow.  Indeed consumers may also get nervous about spending money.

If, however, we can have credit cards, then we can just go out and buy what we want without thinking about it.  The money in circulation then becomes liquid, as it flows onto the markets.  Indeed at times in the US, it doesn’t actually flow, it is more like a cascade from Niagara Falls.

This kind of spending is great when everything is looking perky on the economic front, but in the US, the credit crunch hit with a bang from 2006 onwards.

People who had acquired not just one mortgage, but two and a number of credit cards, found that they could not make the payments on their mortgages or on their credit cards.  Debts started to accumulate and things got very tight for people, particularly those who lost their homes and who faced crippling mountains of debt.

Consumer spending thus contributed to the credit crunch (albeit in a small way) but it is more the philosophy behind it that is interesting.  The extensive use of credit cards and consumer spending that just increases and increases, with little perception of the consequences, has also made the US economy vulnerable.  People spent and spent, they consumed and consumed.  They didn’t think about how they were going to pay all that money back.   Then oil prices started to go up and the dollar weakened.  Gas cost more and so living expenses were higher and suddenly it was impossible, or at least very difficult to get more credit.

So the US was being shown, effectively, that everything comes at a price and that consumers had consumed, but now they had to pay for their consumption.

The government however, had done little to challenge the consumer habits of its people.  It had adopted an approach of just letting things be, in the great American tradition.  Yet by simply allowing consumer spending and consumption to carry on, rampant and unchecked, the government ultimately did its citizens no favour.  It simply let them become vulnerable.

The European Central Bank does seem more concerned with controlling certain aspects of the European economy, thus offering its residents at least a little more protection in terms of the credit crunch.

So the US seems to almost have been sleepwalking into the mess it now finds itself in, whereas the EU, through its Central Bank, has taken a much more protectionist attitude.  But compared to the US, it is certainly looking healthier!

OPEC and the euro

OPEC, the oil producing export countries are a very powerful body of countries.  Basically, they control the oil that flows throughout the world.  The middle-eastern countries are actually the most powerful, since they control the oil that is exported from the middle east and although oil may be produced in other parts of the world, the middle east is really the area that counts.

OPEC, since 2006 have been switching their money from holdings that are in dollars to the euro.  This means that the OPEC countries prefer to hold euros because they perceive it to be a stronger and more resilient currency.  If they have dollars, whilst other currencies become stronger, then they lose money.  If, however, they can have euros, then as the dollar declines, they will make more money, since the euro will get stronger.  This ‘switching’ started in 2006, when in one year they switched over $5 billion from dollars to euros. 

Effectively this sent out a signal that OPEC was switching sides, instead of backing the dollar, it was going to back the euro and to some extent the yen.  These looked safe, whilst the dollar sadly, did not.

This was a clear indication that the dollar no longer had, to a large extent, a monopoly on being the preferred currency of the world.  In short, the dollar was starting to lose its grip.

This decline was then further exacerbated by the fact that the dollar could buy less oil.  As the dollar became weaker, it had to pay out more for imports.  Since oil is imported, this meant that less oil could be bought for $100.  The costs of increased oil had to be passed on to the consumers in the form of increased gas prices and so the US becomes even worse off and its cycle of decline becomes stronger.

The US and the weak dollar

Some economists argue that for the US, the weak dollar is not the end of the world.  When the dollar is weak, then American capital markets look a more attractive option for foreign investment companies.  In addition, the weak dollar makes the US a preferred destination for overseas visitors.  Since they can get quite a lot of dollars for their money, then can then inject capital into the economy and this time, it is cash from outside that is being injected, not just credit circulated internally within the US.

In addition, the trade deficit can be eased somewhat.  US companies will find that their goods become more readily affordable to overseas firms, so there is actually increased trade and the deficit can be eased.

Yet, these arguments almost fail to take account the context in which the dollar is weak.  Ordinarily, yes, the weak dollar could cause the effects such as more visitors and better trade. 

But the US tourist industry has not fully recovered since 9/11.  Some people are still concerned about the risk of a terrorist attack, so they do not visit.  Whilst many more visitors are coming than in the immediate aftermath of 9/11, it would have been reasonable to think that the weakness of the dollar would have had people pouring into the country, but this has not happened.

Moreover, the credit crisis also affects trade.  Many businesses were hit by the credit crunch, as individuals and as businesses.  Small businesses in particular were hit.  So this meant that some businesses had gone bust, so they simply weren’t in a position to trade with foreign companies, so the weak dollar was little comfort to them.

In addition, the culmination of the credit problems, the weakness of the dollar and the general, even sharp decline of the US economy, undoubtedly led to a lack of confidence.  The US started to become fearful and nervous about how bad things were going to get and this depression started to seep into the national psyche.

So for the US, there is little in the way of joy that the dollar is weak and it is likely that the dollar will simply decline and may even have to undergo the humiliation of being devalued.  Only time will tell.  But how does the rest of the world view the weak dollar?

Global responses to the weak dollar

The main rival to the dollar, namely the euro, is controlled by the European Central Bank, which is obviously not losing too much sleep over the fact that the dollar is weak.  As the dollar declines, the euro starts to creep up and become more and more powerful.  It is much more stable than the dollar and thus it can look forward to perhaps even knocking the US off its position as the No 1 currency in the world.

Due to the fact that oil is priced in US dollars, the costs for oil throughout Europe, particularly those countries that have the euro as their currency, has managed to be kept significantly lower than in the US.  So, again, Europe wins.

There are also some hidden casualties from the weak dollar though.  The aid that the US gives to developing countries has now much less worth than it had before, so they are less able to develop.  However, this to some extent can be counterbalanced by the fact that any aid they get from Europe and the UK in particular will be worth more.  It depends on the ratio of US and European funding: some countries will be winners, others will lose out.

Lessons to be learned

In a few years time, or even a couple of decades down the line, economists and historians may point to the weakness of the US dollar as being the time that the current started to flow against the US.  Instead of being the absolute world dominant currency, the US now started to be viewed as a leading currency, but not as the leader.

However, until the dollar regains some of its strength, there appears to be some unease globally about how the world can recover from all the crises that has hit its various economies over the last few years.

Perhaps some good will also come from the weak dollar in the sense that the US can no longer assume that it is the dominant economic leader and it has to earn that position, not simply assume it as a given.  More importantly, perhaps the rest of the world can also learn that if we simply consume, without the means to repay, there will be a cost, somewhere along the line.