Falling Dollar

November 16, 2004

There is no question right now that the US dollar is falling relative to foreign currencies. The important issue is what effect the falling dollar will have. The New York Times suggests three possible scenarios:

1. The US can continue to borrow indefinitely because today's financial markets have created a virtually unlimited source of capital.

2. The dollar will be propped up by Asian countries; a strong dollar benefits their labor and export markets

3. The dollar will collapse, leading to unemployment, inflation, and overall nastiness in the US economy.

I personally believe in choice 4: none of the above. My suspicion is that, as the dollar becomes weaker and weaker, the ability of Asian governments to maintain a high dollar will be tested. In particular, China, which currently pegs its yuan to the dollar, will find it untenable to maintain current exchange rates. While China would not want to harm its nascent economy by lowering the yuan peg, its ruling body would find the idea of black markets for currency or for valuable imported goods. I suspect China would be forced into devaluing the yuan, yet keeping it pegged to the dollar. This might cause some temporary choppiness in the global economy, but not the stagflation of the 1970's. Interest rates would probably rise a few percentage points, unemployment would creep higher, and imported goods would cost more. Still, there are too many interested parties concerned with keeping the US dollar relatively high. It would take a significantly larger shock to the global economy to cause significant stress on the dollar to create a tailspin scenario. The most likely stress of this magnitude would be if Asian borrowers decided not to repurchase US dollar denominated debt. This is not very likely - the US Treasury is universally considered the world's safest investment. Asian investors have stuck by while plummeting interest rates plus a falling dollar have shrank returns on US bonds to near nothing. Now that rates are rising again, pulling out of the US is far less likely.