On the declining U.S. dollar

My commentary on the issue that was published in the Business Times of Singapore:

Business Times - 19 May 2006


DECLINING dollar reflects US policy failure

By LEON HADAR
WASHINGTON CORRESPONDENT

THE conventional wisdom in Washington is that President George W Bush hasn't been rewarded politically for a mostly booming US economy. Indeed, his approval rating in the public opinion polls is now somewhere in the low 20s, despite the fact that the indicators reflecting the resilience of the US economy - inflation (low), interest rates (relatively low), consumer spending (relatively high), unemployment (relatively low) - should have helped transform the current White House occupant into a popular president.

Most pundits explain that paradox by suggesting that Mr Bush's policy failures in Iraq and in dealing with Hurricane Katrina, a series of scandals involving officials and Republican lawmakers, and recent rising energy costs have counteracted any positive effect that the booming economy should have had on his standing in polls. But pollsters also point out that notwithstanding the good economic news, most Americans are uneasy about their long-term prosperity as a nation.

In a way, the anxiety among Americans reflects concerns over the continuing effects of globalisation on the American economy and society - the slow erosion in the US manufacturing base as a result of technological changes and competition from emerging economies; the dramatic demographic changes that have been produced by rising illegal (and legal) immigration; and the financial and human costs involved in maintaining the pre-eminent US global military position.

There is, however, another indicator that may explain why Americans seem so irritable these days. That has to do with the value of the US dollar falling 28 per cent against other currencies between 2002 and 2004. It then bounced back slightly, only to fall again against the euro and the yen in recent weeks. Representative Ron Paul, a Republican, who is the leading 'goldbug' on Capitol Hill, traces today's financial problems back to the removal of gold backing from global currencies. He argues that the real measure of just how far the US dollar has fallen can be found in the price of gold, which has reached a 25-year high of more than US$700 per ounce.

'It's much more accurate to measure the dollar against a stable store of value like gold, rather than against other fiat currencies,' Mr Paul writes in LewRockwell.com, a web site affiliated with the Misses Institute.

According to him, the declining US dollar as measured by the rising value of gold will continue 'until the American people demand an end to deficit spending by Congress and unrestrained creation of new dollars by the Federal Reserve and Treasury department'.

Or to put it differently, 'voting' for gold is a vote of no confidence in the ability of the Administration and Congress to control the budget and trade deficit, the Fed's ability to control the money supply, and by extension, the ability of Washington to pursue its hegemonic policy in the Middle East and elsewhere.

Most investors recognise that the federal government's huge debt and deficit spending will continue to grow as the costs of US military intervention abroad will rise and make the American economy more dependent on foreign governments and central bankers.

Indeed, in 2005, America's current account deficit with the rest of the world exceeded US$800 billion or about 6.5 per cent of GDP. As any economist will tell you, at some point Americans will have to start repaying what they borrowed abroad or they would face a world that refuses to lend them more money. Such a repayment of debt would have to be linked up to a big drop in the value of the US dollar.

Michael Mussa, former director of the International Monetary Fund (IMF) told John Maggs of the Washington-based National Journal that the value of the US dollar would have to drop by 25 per cent to have any impact on the US current account deficit. In turn, a lower US dollar will force higher interest rates, which will slow economic growth.

It's not inconceivable that foreign investors will decide at some point that the risk of investing their capital in the US outweighs the benefits and shift their investments to other currencies. According to Mr Mussa, the worst-case scenario would be a 'dollar crash' which could take place if speculators bet that the US dollar will continue to fall and devaluation begins to feed on itself, threatening China and other economies that tie their currencies to the US dollar.

Mr Paul believes that the world financial markets are already starting to bet against the US dollar. 'Our creditors, particularly Asian central banks, are losing their appetite for US Treasuries,' he writes. The long-term significance will sink in when Americans understand that the steady erosion of the value of the US dollar means they will all be poorer in the future.

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