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Dollar Depreciation

Economic Effects of U.S. Dollar Depreciation

News on the effects of the deprecation of the U.S. dollar depends on the source. Opinions on the effects of U.S. dollar depreciation range from gloom and doom to hardly any effect at all. The depreciation of the U.S. dollar has an effect on the willingness of people to incur major debt or to engage in travel. Whether the reports are minimizing a real problem or inflating a minor occurrence, the news and speculation alone have the ability to change consumer habits, both in the U.S. And abroad. This research will investigate the hypothesis that the depreciating dollar will help to rebalance the trade deficit, resulting in a stronger overall global economy.

Understanding Dollar Depreciation

Americans are used to living in a country where dollar depreciation was not a problem. They became accustomed to a relatively stable dollar, compared to other countries. The dollar has been historically so stable that it has been used as the standard against which to measure other forms of currency. However, recent depreciation of the dollar has left many Americans weary of their spending habits. One of the key reasons for the panic is that Americans are simply not accustomed to the level of instability recently experienced. This is the key reason that underlies the hype regarding depreciation of the dollar.

The reasons for the depreciation are not difficult to understand from an economic standpoint. Depreciation of the dollar is a result of the U.S. government borrowing nearly $665 billion annually from foreign lenders. These funds are being used to finance the gap between payments to and receipts from other countries (Rivens, 2004). This price tag amounts to approximately $5,500 per household every year. This level of borrowing is not new and has been going on for quite sometime. Borrowing entails a cost, whether the borrower is an individual, business, or the U.S. government. However, the American public did not notice it, as it was offset by low interest rates (Rivens, 2004). This is no longer the case and the average American is beginning to feel the crunch.

The current trade deficit has been driven largely by the merchandise trade account. Merchandise accounts for nearly 90% of the current debt of the United States (Rivens, 2004). The current problems began in 1997 with a rise in the value of the dollar. As the dollar rose, U.S. demand for imports rose due to falling prices. However, the other side of the coin is that as the cost of imports fell, the cost of exports rose. This lowered demand for U.S. products and increased demand for foreign products (Rivens, 2004).

Eventually outstanding accounts outpaced accounts receivable and the U.S. was soon in a borrowing, rather than profit position. A small debt to income is not problematic, as long as it is resolved before it grows too large. However, this is not what happened with the U.S. economy. Demand for imports continued to grow and demands for exports continued to fall. The trend was not steady by any measure, and there were brief periods where it looked like the U.S. might be on the road to recovery. However, these periods were short-lived and over the long-term, the debt grew, as compared to revenues from exports. By 2004, the trade deficit was equal to 5.2% of the GDP (Rivens, 2004).

Dollar Depreciation and Global Competitiveness

One of the key advantages that made the dollar attractive is the competitiveness of the U.S. In the global marketplace. The U.S. was an early player in the global marketplace, largely due to advances in technology and a highly developed infrastructure. This created a ripe environment for American ingenuity and the development of manufacturing enterprises. For many decades, the U.S. And other industrialized nations enjoyed a narrow competitive outlook. The number of producers that could compete on a global basis was limited by technology and access to the market. This allowed these countries to gain market domination, allowing their economies to grow strong.

However, this has changed. Communication advances have allowed countries that were unable to compete on a global basis to enter the global marketplace. The former superpowers are losing ground to competition. Even if the new comers to the global market do not achieve domination over the larger industrialized nations, they can still take a bite out of the market share. This reduces the chance for export revenue as the U.S. And other industrialized nations receive an increasingly smaller piece of the pie. The global marketplace is no longer a cornered marketplace for the U.S.

As newcomers become more competitive, the U.S. must take actions to make their goods and services more attractive to foreign markets. The current dollar depreciation is a correction that was foreseeable to economists long ago (Rivens, 2004). The depreciating U.S. dollar means lower export costs and will increase demand for U.S. products, at least in theory. The effects of this correction will have differing outcomes for each individual country that is a trading partner. For instance, the dollar correction as compared to the euro has recently experienced dramatic shifts (Rivens, 2004). This is the first step to correcting current account deficits (Rivens, 2004).

China, Malaysia, and Taiwan enforce a hard peg of their currencies in relation to the valuation of the dollar (Rivens, 2004). These countries will buy mass amounts of U.S. dollars on the global market in order to stabilize their own currencies. They do not allow fluctuations of their currencies to expand outside of a predetermined narrow band (Rivens, 2004). Current fluctuations in the U.S. dollar may force them to change their fiscal policy in regards to the U.S. dollar.

What does the future look like?

The costs of the debt remained cleverly hidden by the Federal Reserve's attempts to hold down interest rates. However, recent economic shifts have prompted them to increase interest rates. The American citizens are now beginning to notice their declining dollar. Continued borrowing will have dire consequences, according to some experts. It is projected that if the current account deficit continues to rise at the current rate the external debt of the United States will increase to 64% of the national GDP by 2014 (Rivens, 2004).

This means that a majority of the GDP will be spent financing debt, rather than being used for programs and infrastructure improvements. This is a bleak picture for the American citizen because it could mean higher taxes, higher interest rates, and an even greater depreciated dollar value. This is the opinion of many gloom and doom analysts, who project that the good times are over for the American public.

This opinion does not consider the positive effects of dollar depreciation, which will be discussed later. However, for now, let us assume that the bearish trend will continue and the purchasing power of the American citizen will decline. This projection suggests that the government will continue to spend more than it earns and that the debt will outpace income at an increasing rate (CBO, 2004). The following is a projection of the how the bottom line for the United States may look if the current trend continues. (Source: Congressional Budget Office. 2004. Current Economic Projections, 2004-2014. In Rivens, 2004)

When the U.S. is in a higher debt to income position, it has the effect of decreasing the value of the U.S. dollar, as compared to other currencies of the world. This will reduce the value of future income generated by capital stock (Rivens, 2004). As the debt continues to grow it will place intense pressure the ability of Americans to continue their current living standards. However, only the future knows if the current predictions will hold true. The Central Budgeting Office feels that the debt will continue to grow. However, these projections are based on a number of assumptions that may or may not hold true in actuality.

The current dollar correction will help to stabilize the import/export ratio of U.S. goods. However, the real question is how long the correction will continue. Some analysts paint a glum picture where the dollar will continue to fall even more dramatically in the future. These analysts contend that continued dollar depreciation will have a negative impact on the economy (Obstfeld & Rogoff, 2005). However, other feels that the response to the correction has been sufficient to project that it may be at it lowest, or near its lowest (Corsetti, 2007). Both of these opposing views on the future of the U.S. dollar are based on different factors.

According to the IMF, the current U.S. dollar depreciation is a part of the natural rebalancing process and will have a positive effect on the global economy (Reuters, 2007). The IMF feels that the U.S. dollar is a heavily overvalued currency and that the adjustment had been fairly controlled so far. This statement brings up another important point when considering the effects of the depreciation of the U.S. dollar. If one tends to read only U.S. based economists commenting on the effects of the depreciating dollar, they tend to paint a picture of damage and destruction. However, if one expands their outlook to a global perspective, the is only a correction and will help to strengthen the position of other currencies. As the U.S. dollar grows weaker, other currencies grow stronger. The depreciating dollar may cause Americans to alter their lifestyle, however, from a global perspective; the situation is not that dire.

One of the key concerns for investors has been what will happen to commodity futures. According to Abacus Consulting Services and Los Angeles Chinese Learning Center (2005), commodities will be bullish. Commodity prices will increase as the U.S. dollar decreases. However, there was little to support this opinion. Their opinion is based on past trends that indicate that commodity prices are inversely proportional to whether the U.S. economy is in an inflationary or deflationary mode. They point out that during the Great Depression, commodity prices doubles from 1932 to 1934.

Factors that Could Affect the Outcome

Many factors could help to offset the effects of U.S. dollar depreciation including the policies that the Federal Reserve Board decides to adopt in response. It is likely that the Federal Reserve will take measures to correct the situation before a complete disaster results from the continuing trends. Rising oil prices and other energy prices will also be a factor in whether the current trend continues (Abacus Consulting Services & (Los Angeles Chinese Learning Center, 2005).

It is the consensus among analysts that that the depreciating U.S. dollar will close the trade deficit and restabilize the trade balance. Many of these opinions are based on monetary theory and on historical trends. However, some disagree with this analysis. Goldberg & Dillon, (2007) feel that there are several factors that could damper the effects of dollar depreciation to the point where the impact on import prices would be minimized. According to this analysis, the use of the dollar in invoicing U.S. trade, market share concerns of exporters, and rising U.S. distribution costs will offset the positive effects of the depreciating dollar on the trade deficit.

This analysis concludes that dollar depreciation will have little impact on reducing the current trade deficit. As U.S. goods become more attractively priced overseas, it will have a theoretical increase in demand for U.S. goods. However, there are many factors, including rising transportation costs that will force prices to remain high. This will dramatically reduce the effects of dollar depreciation. Goldberg & Dillon (2007) feel that the effects will not change the overall picture significantly. U.S. prices for exports will still remain high due to rising costs. However, the depreciating dollar will help to offset these price increases, perhaps slowing the trade deficit increase to some degree.

The price of gold can give us important clues about the economy and its future direction. This important indicator is often ignored by economists, but it can act as a thermometer by which to measure the overall mood of the consumer. Between 1980 and 200 the price of gold fluctuated little. Therefore, it was of little economic interest. However, since 2001, the price has demonstrated a steady rise, peaking at over $600 per ounce (Paul, 2006). This price rise is not significant in itself. The mechanism that causes gold to rise is of interest in our discussion of the depreciation of the U.S. dollar.

As the value of the U.S. dollar declines, the price of gold rises in proportion (Paul, 2006). A gold standard is an assurance that paper currency has some "sound" form of value. Recently, Alan Greenspan preached that if managed properly, paper money would have the same "sound" attributes as gold. The gold standard represented a rigid discipline in monetary policy. This standard is much freer when currency is the standard (Paul, 2006). To put this in perspective, consider that in 1934 a dollar was worth 1/20th of an ounce of gold. In other words, $20 would buy an ounce of gold. However, in 2006, a dollar was worth 1/600th of an ounce of gold. It would take $600 dollars to buy one ounce of gold.

The same types of rises have been seen when one compares almost any other staple commodity over the same time period. However, gold gives us a tool to measure the depreciation of the U.S. dollar. When one examines rising gold prices as a reflection of he depreciation of the U.S. dollar, it appears to be an alarming situation. For the average American, if their money will buy less gold, it will also buy less of other commodities as well. They now feel that they have to work harder in order to afford the same lifestyle that they enjoyed for less several years ago. Americans do not make it a habit to check gold prices, but they do feel the pinch in the average cost of living. Gold simply provides a set commodity quantity against which to measure the decline of the dollar.

Foreign policy is another factor that plays a significant role in the economy and the value of the dollar. The American public would never tolerate direct tax increases to fund a foreign war under the gold standard (Paul, 2006). However, with the ability to create currency at will, the real costs of war can be hidden from the people to curb their resistance to the war from a financial standpoint (Paul, 2006). Paul argues that although the U.S. public does not directly see the effects of the war on their lifestyle, war still has an effect by boosting spending. This increases the national debt, leading to inflation. However, because these effects are indirect, the average citizen does not attribute the source of their woes to the war.

Paul argues that the price of gold has not risen, the value of the dollar has fallen. This is an interesting slant on our understanding of gold prices. According to this analysis, one could estimate that the value of the dollar has fallen by 60% (Paul, 2006). However, one must ask if this analysis is a narrow approach to a much larger picture. According to Nielson (2007) the decline in the dollar has only mounted to 13% in the same time period. These two numbers apparently considered different factors in their calculations. Differences in calculations account for many of the differences in opinions regarding the future outcome of the current bearish trend in the dollar.

Nielson (2007) agrees that a weakening dollar has helped to offset the trade deficit and that it has been a blessing in disguise. In May of 2007 exports reached an all-time high of $132 billion (Nielson, 2007). This demonstrates that foreign demand for U.S. products has responded to the price adjustments created by a devalued dollar. As the dollar weakens, demand for U.S. goods increases both domestically and abroad. The trade deficit is decreasing, which should free up funds to help pay back some of the national debt, at least if politicians decide to spend it in that manner.