Devalued Dollar?

Are you planning a trip to Paris, Milan, or Savile Row in London for some fancy new duds? If you are, you may be in for a surprise. Your dollars may not purchase quite as many suits, dresses, and shoes as you had hoped. But, then again, if you're the sort who jets off to Europe for the latest in couture, it may not matter to you anyway.

It's difficult to know what currency fluctuations mean in ordinary people's day-to-day lives. Currency is a realm where government and high finance intersect in complicated ways. It also happens to be the realm where George Soros made his billions, betting on this or that currency to decline or become more valuable at various points. Warren Buffett, by contrast, seems to avoid these kinds of "macro" trades, preferring to concentrate on individual companies' prospects and taking an ownership stake when he thinks the situation warrants it. Nevertheless, Buffett reportedly has a rather uncharacteristic and large bet down against the dollar currently. Currency is a hot topic lately.

Let's take a few recent articles and try to piece together what's going on with the dollar in relation to other currencies, trade, the budget deficit, and interest rates. That sounds like an awful lot, but it's difficult to talk about any one of these things without the others. Have no fear; we'll keep it simple. In any case, my own limitations in this area will necessitate simplicity.

First of all, The Wall Street Journal today accuses the Bush administration of "weak dollar complacency." The dollar is weak, and the administration is allowing it to languish. A devalued dollar could lead to a stock market crash as occurred in 1987, the last time the dollar was this weak. Investors, domestic and foreign alike, do not want to invest in a country that devalues its currency. When you invest in a company that is based in and does most of its business in a foreign country, you are, in effect, exchanging your own currency for that of the other country because that company makes profits in the foreign currency. This makes American companies that earn profits in devalued dollars unattractive to foreign investors. (It also makes it unattractive to Americans who may prefer to invest their dollars in companies who make their profits in euros or yen.)

The Journal also criticizes John Snow for disingenuously claiming that he favors a strong dollar. Snow is also taken to task, however, for his laissez faire argument that he favors markets establishing the value of currencies on their own. Currencies are controlled by a cartel of central banks, argues the unshakable voice of tax-cuts and supply-side economics; and it is time for the American branch of the cartel, the Federal Reserve, to take measures to strengthen the currency. The administration is sorely mistaken, according to the Journal, if it thinks it can "devalue its way to prosperity."

Let's pause for a moment to ask some questions. What does devaluation of the dollar have to do with prosperity? If the dollar is weak against the euro, yen, and other currencies, then foreign countries are encouraged to purchase our goods; if their currency is stronger, they have greater purchasing power with regard to our goods. This, of course, ameliorates the current large trade deficit that we are experiencing.

Another way in which a devalued currency stimulates prosperity has to do with the function of the Federal Reserve alluded to by the Journal. The Federal Reserve controls short-term interest rates, as many know, but in the process it also controls currency. The Fed controls rates by setting the discount rate but also by purchasing or selling U.S. debt. If it purchases debt, it raises the price of that debt which lowers the interest rates. But it also devalues the currency by flooding the market with dollars. So recent attempts to stimulate the economy (resulting in 45-year lows in interest rates) have had the effect of devaluing the dollar. (Remember basic supply-and-demand from economics 101: the more there is of something the less valuable it generally is. Flooding the market with dollars will devalue the dollar, just as flooding the market with anything else will devalue that commodity.)

So far so good: the Fed floods the market with dollars when it buys treasuries. But it appears that when foreign governments buy treasuries with dollars that they've received from trade, the value of the currency appreciates. By absorbing dollar-based assets, they increase the value of the dollar. This is exactly what China is doing in an effort to keep their goods affordable to us.

The weaker our currency gets, the less imported goods we're able to purchase. The effects on interest rates are the same no matter who's buying the debt; if there's demand for the debt, prices will go up and rates will go down.

So the US's effort to stimulate the economy combined with China's and Japan's effort to prop up the dollar result in everyone buying US debt. These efforts have opposite effects on the value of the dollar (depending on the purchaser) with an overall weakened currency resulting lately but a coordinated or combined effect to lower rates (to 45-year lows) and raise prices of treasuries.

In any case, the Journal thinks that allowing the dollar to languish is a bad policy. So the editors call for Alan Greenspan to raise rates in an effort to prop it up, strongly implying that he is as guilty for it's current weakness as the administration.

Similarly, Irwin Stelzer argues that overseas observers have learned a new colloquialism -- "Snow Job" -- in understanding that Secretary's Snow doesn't mean what he says when he defends a strong dollar. Stelzer also indicates that the euro is bearing the brunt of the dollar's demise, making European goods ever more dear and contributing to Europe's economic weakness. The one benefit for Europe is that, since oil is traded in dollars, it takes less euros to buy those dollars. Stelzer seems to be more optimistic than the Journal editors, however, that Greenspan will continue to raise rates.

Finally, the loudest booster the American economy has ever had, Larry Kudlow, argues that the dollar really isn't weak. According to Kudlow, "[S]ince February 2002, the dollar has fallen 14 percent from a greatly overvalued position that deflated the U.S. economy into recession. However, over the last 10 years, this broad-dollar index is basically unchanged. The dollar is at nearly the same point today as it was in 1994. During this period the average inflation rate in the U.S. was 1.8 percent." Moreover, the dynamism of the American economy whose companies enjoy the largest profit margins in the world will continue to attract foreign investment; the Journal's fear of a market collapse is unfounded. "Cowboy capitalism" will continue to prove irresistible to foreign investment. "In order to get a piece of Bush?s ownership-society vision, foreign investors are going to have to buy dollars, not sell them." Agreeing with Stelzer, Kudlow thinks that Greenspan and the Fed will continue to remove gradually the excess dollars they created after 9/11.

So there you have it: A quick lesson on currency and interest rates with reference to three recent articles.