Trashing the dollar to save the economy

Market Beat

Most Americans have never traveled abroad. U.S. economic policy may guarantee that your dream trip remains deferred.

If something’s got to be sacrificed to put the domestic economy on the road to a sustainable recovery, the dollar’s value against other currencies seems a good candidate.


That’s what the Federal Reserve signaled this week — and what Congress, in no uncertain terms, is telling the Chinese.

A new devaluation of the buck carries risks. Always high on any Wall Street list of potential calamities is the idea of a sudden collapse of the dollar. That still seems remote, though perhaps less so than in the past.


Fed policymakers seem prepared to take their chances: They strongly hinted in their post-meeting statement Tuesday that they’re ready to flood the financial system with more dollars to try to push longer-term interest rates lower.

That helped drive the greenback’s value to the lowest level since March against a basket of six other major currencies, including the euro and the yen.

Meanwhile, Congress made clear that it’s running out of patience with China over that nation’s policy of holding its currency, the yuan, artificially low against the dollar to keep Chinese export prices cheap. The U.S. House Ways and Means Committee on Friday approved a bill that could boost tariffs on China’s exports to the U.S. if Beijing fails to agree to let the yuan rise in value.

Check your wallet: “What Congress is asking is for Chinese goods to be more expensive,” notes Michael Woolfolk, currency strategist at Bank of New York Mellon. What was the last thing you bought that wasn’t made in China?


The standard line from every administration since the 1980s is that the U.S. favors a “strong dollar.” But that often has been a lie, and perhaps never more so than today.

The “almighty dollar” really hasn’t lived up to that billing since 2002, when its value against major rivals reached what stands as a 25-year high.

If left to the free market, currencies rise or fall based on a host of variables, including the strength of a country’s economy, its level of interest rates and its inflation rate. In general, money prefers to be where it’s treated well.

The dollar’s slide since 2002 in part reflects the economic ascendance of countries such as Brazil and Australia, which have benefited from a global boom in natural-resource demand, particularly from China.


At year-end 2002, one Australian dollar cost just 57 U.S. cents. Now you’ll have to pony up 96 U.S. cents. So a snorkeling trip on the Great Barrier Reef has become far more expensive for Americans.

But the flip side of the dollar’s decline is that U.S. goods and services have become more affordable abroad. Total U.S. exports, which had stagnated in the late 1990s, jumped from $977 billion in 2002 to a record $1.84 trillion in 2008, before the financial system crash.

With the domestic economy still weak and job growth anemic, the Obama administration sees exports as a huge opportunity. The president has set a goal of doubling exports within five years. A falling dollar obviously would help.

Although manufacturing accounts for just 11% of the U.S. economy, many of those jobs pay well. Nobody wants to lose more of them.

That’s also how China feels about its own manufacturing sector. If the yuan were to surge against the dollar, Chinese exporters would either have to raise prices of their goods, accept smaller profit margins, or both.

Chinese Premier Wen Jiabao, meeting with Obama in New York this week, said his country would suffer massive factory bankruptcies and “major social upheaval” if China’s government allowed the yuan to appreciate 20% to 40% as some critics have demanded.

China has insisted on revaluing the yuan at its own pace rather than subject the currency to the free market. From mid-2005 to mid-2008, the yuan strengthened to 6.83 per dollar from 8.28, a 22% gain in value. Beijing then held the yuan steady until three months ago, when it allowed the slide to resume — but glacially. The yuan now is at 6.69 per dollar, a 2% gain since mid-June.

That has infuriated U.S. manufacturing groups, which have been pressing Congress to all but threaten a trade war with China to force the government to boost the yuan.

China “will never agree to a currency adjustment until they have the proverbial gun to the head,” said Scott Paul, executive director of the Alliance for American Manufacturing.

Even if the Chinese were to cave in, no one would expect a drastic overnight revaluation of the yuan. Barry Eichengreen, an economics professor at UC Berkeley and an expert on currency issues, said a 10% annual rise over a period of several years would be a reasonable hope.

Besides appeasing American industry, any acceleration in the yuan’s appreciation also would serve the Federal Reserve’s purposes as it faces its biggest fear: the threat of deflation, or a sustained decline in prices.

If prices of many imports at your local Wal-Mart or Target rise even slightly, or at least don’t fall, it could be that much harder for a deflationary spiral to take hold.

We all like paying less, but the Fed is afraid that, amid tepid demand, many consumers will begin to believe that prices can only go down if they wait to buy. That could push the economy back into recession, or worse.

The Fed’s post-meeting statement this week signaled that inflation, which by some measures now is running at less than 1% annualized, had fallen too low for policymakers’ comfort. They said they were “prepared to provide additional accommodation if needed” to lift inflation to levels consistent with “price stability.”

The central bank’s next act, if the economy fails to pick up speed, is expected to be a new round of so-called quantitative easing: The Fed would, in effect, print money — and lots of it — to ramp up its purchases of Treasury bonds or other debt. The aim would be to stoke the economy by pushing longer-term interest rates down further.

At least in theory, a side-effect of flooding the financial system with more dollars would be to devalue them around the globe, making it easier for domestic manufacturers to compete at home and abroad with foreign rivals.

Yet the U.S. isn’t the only country that would like to export its way out of this economic swamp.

Japan, which despite slow growth has had to contend with a rising yen — in part a function of the country’s continuing huge trade surplus — finally reached its limit two weeks ago when the yen hit a 15-year high against the dollar.

The government stepped into the market to buy dollars and sell yen for the first time in six years, hoping to arrest the yen’s climb for the sake of the country’s exporters. It worked — until the Fed knocked the dollar lower this week.

If the global economy weakens further, a key risk is that governments could engage in a race to the bottom with their currencies via repeated devaluations reminiscent of the 1930s. The U.S. could lose that race, meaning the dollar could rise instead of fall against its major rivals, confounding the export push.

There’s also the risk that any drive to gradually devalue a currency could spin out of control by eroding confidence in that paper, leading global investors to rush to cash out of assets denominated in the currency before their losses worsen.

The potential for a mass dumping of dollars has been a favorite theme of Wall Street bears for decades. The more dollar-denominated assets in the world (think: Treasury bonds), the more investors there are to sell.

But as recently as last spring, when Europe’s government-debt crisis flared, the world showed yet again that in times of turmoil people run to the dollar, not away from it. It helps the buck’s standing that no alternative currency has the critical mass to replace it.

“The dollar is still the linchpin of the world financial system,” says John Taylor, head of FX Concepts Inc., the world’s largest currency hedge fund.

Still, the ongoing bull market in gold, which hit a record high of $1,296 an ounce Friday, shows many investors are mistrustful of paper currencies in general. And Americans’ continuing hunger for mutual funds that invest abroad suggests a desire to hedge against a dollar meltdown.

The U.S., as a chronic debtor, needs the rest of the world to love the dollar while continuing to tone down the affair at a manageable pace. It’s a lot to ask of any relationship.