Skip to: Content
Skip to: Site Navigation
Skip to: Search


Facing up to the falling dollar

Don't panic just yet. But watch out for Washington's attempts to 'rescue' the dollar.

By Donald J. Boudreaux / November 28, 2007



Fairfax, Va.

What do Venezuela's Hugo Chávez, Iran's Mahmoud Ahmadinejad, and rap mogul Jay-Z have in common? They've all recently dissed the US dollar. And for good reason. Seven years ago, a euro would set you back as little as 84 cents. Today, it takes a whopping $1.49 to buy a euro. The trend line with respect to other currencies is similarly negative.

Skip to next paragraph

The precipitous drop in the dollar's value has set off alarm bells around the globe. Will China dump its massive hoard of dollars? Will OPEC stop trading oil in greenbacks? Will Persian Gulf states break their peg to the dollar? How low will the dollar go?

The response to all of these concerns is this: Be afraid, but not very afraid. Yes, the dollar's fall makes Americans poorer. It also reflects concerns about the health of the US economy. But so long as policymakers refrain from greater protectionism, foolish regulations, and loose monetary policy, the US economy and currency won't become second-rate.

The consequences of the greenback's decline are serious but manageable. The causes are more worrisome.

Consequences

The worst consequence of a falling dollar is that it erodes America's terms of trade. The lower the dollar, the fewer the imports that Americans receive as payment for a given amount of exports. For example, if in 2004 Caterpillar received €500,000 for each bulldozer it sold to Europeans but today receives only €400,000 for the same bulldozer, clearly this American firm's ability to command European goods, services, or assets in exchange for selling its product has declined.

Americans might indeed export more as a result of the dollar's lower price, but they'll receive less value in return for each dollar's worth of exports. Workers are worse off whenever their earnings buy them fewer goods and services. Likewise, Americans collectively are worse off now that their exports bring them less value, and now that their currency buys them fewer foreign goods and services.

Another negative likely consequence is Congress "coming to the rescue" with more protectionist policies. Grabbing any excuse for protecting favored domestic industries from foreign competition, many in Congress will use the dollar's fall to "shield" the American economy from the "unfair" and "destructive" globalized economy. But a key reason for the dollar's traditionally high value is that America is the biggest piston in the global economic engine. Reducing America's participation in the global economy will "enrich" Americans in the same way that reducing a worker's participation in the labor market will enrich that worker.

Some observers worry that foreigners will sell their dollar-denominated holdings, causing a spike in US interest rates. Especially during this time of turmoil in the mortgage and credit markets, such a rate spike could cause further pain for homeowners because higher real interest rates are likely to depress housing prices further.

But the mere fact that foreigners hold lots of dollar-denominated assets is no reason to worry that these assets will suddenly be dumped. In a 2005 interview, Charlie Rose asked the late Milton Friedman if dollar dumping by foreigners would be destabilizing. Mr. Friedman pointed out the obvious: "Yes, it might. But the people who would lose by it would be the foreigners who held that and who dumped those dollars."

The fact is, foreigners have little incentive to inflict losses upon themselves by dumping dollars for the sake of destabilizing America's economy. If investors flee the dollar, they will do so only because a worsening of policies in Washington makes dollar-denominated assets less attractive.

A falling dollar will also tend to reduce America's trade deficit. Contrary to popular opinion, though, this result is nothing to cheer about.

Far from being a curse, a large US trade deficit signals that the American economy is structurally sound. The reason is that this "deficit" rises as foreigners increase their investments in the United States. Because investors generally do not pour their funds into assets whose expected returns are poor, a growing US trade deficit signals global optimism about the future of the American economy.

Permissions