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December 2009/January 2010 – Web Exclusive

State of the Dollar

“Markets ultimately punish bad behavior. It’s what they do.”

– Michael W. Brandl,
McCombs School of Business.

Weathering  the Storm - A Series of Reports  on the Texas  Economic Climate

by Bruce Wright

Dr. Michael W. Brandl
Senior Lecturer in Economics and Finance,
the University of Texas at Austin
McCombs School of Business

In recent months, the U.S. dollar has taken a pounding in international markets, losing value against most major foreign currencies and prompting speculation that other nations may abandon the use of the dollar as a “reserve currency.”

To get an idea of what this trend may mean for the state and the nation, Fiscal Notes recently spoke with Dr. Michael W. Brandl, senior lecturer in Economics and Finance at the University of Texas at Austin McCombs School of Business.

To go to the heart of the matter: Why is the dollar falling? And do you expect the drop to continue?

Last question first – the dollar is probably going to continue falling in value.

When you have a current-accounts deficit – when you’re importing more than you’re exporting – the value of your currency should fall. It hasn’t, over the last 20 years or so, in part because there have been deliberate efforts to prop up the value of the dollar. The last three presidential administrations followed a strong-dollar policy. They continued to intervene in the market and prop up the dollar.

Presumably, a strong dollar helped at least some aspects of the economy.

Well, a strong currency means you can buy labor cheaply in foreign markets. It’s one of the things that led to so much outsourcing by American companies.

It’s not so good if you’re an exporter, though, and that’s one reason why U.S. manufacturing has taken it on the chin. Arguably, the strong-dollar policy contributed to the current financial crisis.

So there’s a need for readjustment. And when we get our currency’s value back into balance in global markets, yes, some will suffer, certain industries, certain firms, but others will benefit.

So who’s likely to suffer?

Firms that thought the route to great profits was simply chasing low wages and low-cost providers. When the value of currency drops, those cheap foreign suppliers become expensive.

We have to realize that huge parts of the American management model are dead. The obsession with short-term earnings and stock price, the idea that you can continue to wring greater productivity from technical and knowledge workers and use the increased profitability to pay executives and shareholders – that model is dying. That obsession with short-term profitability, and our failure to evaluate risk correctly, is how we got into this global financial crisis.

But Texas can benefit from a weaker dollar, because of exporting. And if the dollar falls against the currencies of Latin America, we’ll see more shoppers coming to shop in Texas. Many of the Latin American economies are doing very well because they’re selling raw materials to Asia, to India and China.

Could a weaker dollar help revive U.S. manufacturing?

It certainly creates an opportunity. The problem is that a lot of our manufacturing firms are overleveraged – they’ve got too much debt. That will create some great buying opportunities.

As the dollar falls, it will be much cheaper for foreign firms to come in and buy up overleveraged and badly run firms. I think you’ll see European companies gobbling up some of our companies if the euro continues to appreciate against the dollar.

Can we expect a significant increase in foreign investment, then?

I think that other nations are going to realize that we have an American entrepreneurial spirit, a productivity advantage and technological advancements. They’ll understand these opportunities. You put that together with a weakening dollar, and European managers will figure out that their approach to management could be a great way to attract high-quality American workers, especially the engineers. It’s a winning combination for them.

And it would be very good for us. If we could learn from other nations, and learn why our way of doing things has gone awry, and how to fix it – I mean, let’s not just put Humpty Dumpty back together again. Let’s learn from our mistakes.

And do you see any sign that U.S. companies are learning?

Not yet. We’ve had it so ingrained that it’s all about stock price. You’ve got to manage your earnings, and worry about what Wall Street will say about your quarterly numbers. But it’s okay – markets ultimately punish bad behavior. It’s what they do. That’s the beautiful thing about markets.

The Dollar Descends

Since May 2009, the U.S. dollar has lost about 7.0 percent of its value against the European Community’s euro.

see table at end of page


A lot of people are worried that the cheaper dollar could lead to inflation.

I think they’re right to be worried about it. The best way for a government to get out of a high level of debt is inflation. The trouble is, that’s cutting off your nose to spite your face. It leads to other, massive problems.

In the short term, though, we’re not seeing much in the way of inflationary pressures. Long-term bond yields aren’t going up, for instance.

But what about the extraordinary amounts of money the federal government has printed to cope with the financial crisis? Forbes recently noted that the money supply rose by something like $523 billion over the year ending last September.

True enough. We’ve had massive injections of liquidity by the Fed. They’ve never done this at this level before.

The thing is, though, there are these huge reserves sitting in the banking system. And if the banks start lending that money quickly and freely, there’d be a real potential for inflation. But the banks aren’t lending money. So the vast increase in the money supply hasn’t resulted in much spending. It’s a trickle.

And that’s why we haven’t seen a run-up in inflation. But if they start, and the credit flows freely again, we could be in for a real mess.

And how do we head that off?

The Fed will have to mop up all this excess liquidity they’ve created. The question is, can they do that? Can they reduce the money supply fast enough so that they don’t create inflation, but not so fast that it pushes us back into a pretty bad recession? The problem is, history is no guide any more. Nobody knows.

What about the effect of the budget deficit?

When you have a government that runs big budget deficits, they have to borrow the money from somewhere – from the domestic financial markets or from the rest of the world. And when the government borrows this money, it means there’s less for American households and companies to borrow. The cost of capital goes up for them, and then the economy suffers.

Finally, I’d like to ask you about the function of the dollar as a “reserve currency,” and whether it’s losing that status. For all the attention this issue is getting, I suspect most folks are a little fuzzy on what the term means.

Well, national currencies are always being sold in the world market. Now by definition, to buy a currency in the foreign exchange market you need another currency to buy it with. If your currency is the peso, you need to have another currency, like dollars, to be able to keep the value of pesos from plummeting.

That’s all a reserve currency is – you’re holding on to some other currency to be able to buy your currency to keep its value propped up, if it comes under a speculative attack, or the markets go crazy, and your currency starts to drop significantly.

Traditionally, going back to World War II, the dollar has been the currency nations have chosen for this purpose. We had the largest economy, we were stable, growing nicely and so forth.

But if you think about it, it doesn’t make sense to have just one currency as your reserve currency. Say you’re running a small country. The value of our currency could fall not just against the dollar, but the euro, the pound or the yen. It just makes sense to diversify, to hold a basket of currencies in reserve, just like it makes sense to diversify your personal investment portfolio. Countries are no different in that sense.

So you don’t see anything particularly apocalyptic about the move away from the dollar.

From the U.S. perspective, there are good and bad aspects to losing reserve status. There would be less of a demand for dollars in the foreign exchange market, which would, again, lower their value. But ultimately, it’s probably a good thing if the rest of the world doesn’t keep looking to us to ensure the stability of world markets.

Right now, when the Fed is thinking about policy, changing interest rates or whatever, they can’t just look at the U.S. – they’ve got to be concerned about the effects of the rest of the world, because we’re the engine that pulls the rest of the world along. Why do we want or need that burden? Can’t the Europeans or the Japanese step up? FN

For more information on the dollar and foreign currency markets, visit the Federal Reserve Bank of New York.

Read the entire “Weathering the Storm” series:

Text for The Dollar Descends

Dollar’s Value In Euros For the Year 2009
DateOne Dollar Equals:
May 15.74 euros
June 1.70 euros
June 15.72 euros
July 1.71 euros
July 15.71 euros
August 1.70 euros
August 15.70 euros
September 1.70 euros
September 15.68 euros
October 1.69 euros
October 15.67 euros
November 1.68 euros
November 15.67 euros
December 1.66 euros
December 15.69 euros


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