The dollar – stuck in a funk The weak dollar is driving up prices for American consumers. None of the fixes will be easy.

The almighty dollar is mighty no more. It has been declining steadily for six years against other major currencies, undercutting its role as the leading international banking currency.

The long slide is fanning inflation at home and playing a major role in the run-up of oil and gasoline prices everywhere.

Vacationing Europeans are finding bargains in the United States, while Americans in Paris and other world capitals are being clobbered by sky-high tabs for hotels, travel and even sidewalk cafes. Northern border-city Americans who once flocked into Canada for shopping deals are staying home; it’s the Canadians flocking here now.

Everything made in America – from goods to entire companies – is near dirt cheap to many foreigners. Meanwhile, American consumers, both those who travel and those who stay at home, are seeing big price increases in energy, food and imported goods.

The dollar has lost roughly a quarter of its purchasing power against the currencies of major U.S. trading partners from its peak in 2002.

Since oil is bought and sold in dollars worldwide, the devalued dollar has made the recent surge in energy prices even worse for Americans, leading to $4 gasoline in the United States. Analysts suggest that of the $140 a barrel that oil fetches globally, some $25 may be due to the devalued dollar.

Small silver lining

The limp greenback has had one big benefit to the U.S. economy: Since it makes American goods cheaper overseas, it has helped manufacturers who export and other U.S. based companies with international reach. Exports have been one of the few bright spots in an otherwise darkening U.S. economy.

Franklin Vargo, vice president of international economic affairs at the National Association of Manufacturers, welcomes the dollar slide, as do members of his organization.

“We can see that, when the dollar’s not overpriced, that people around the world want American goods and our exports are going gangbusters now,” he said.

He doesn’t see the dollar as undervalued. He sees it as having being overpriced in the 1990s – and what’s happened since as something along the lines of a correction.

Still, Vargo acknowledges the dollar’s decline has brought a measure of pain to some consumers. “As the dollar has gone down in value, that has added to the dollar cost of oil. No question. That’s why we say there’s got to be a balance there somewhere. What we want is a Goldilocks dollar. Not too strong, not too weak. But just right. And only the market can determine that,” Vargo said.

The loss of the dollar’s purchasing power and international respect has some experts worrying that the euro might one day replace the dollar as the so-called primary reserve currency. And that could trigger a dollar rout as foreign governments and international investors flee from U.S. Treasury bonds and other dollar-denominated investments.

Making matters worse: The gaping U.S. current-account deficit – the amount by which the value of goods, services and investments bought in the U.S. from overseas exceeds the amount the U.S. sells abroad – and the low levels of domestic savings means that foreigners must purchase more than $3 billion every business day to fund the imbalance.

Since roughly half of the nation’s nearly $10 trillion national debt is held by foreigners, mostly in Treasury bills and bonds, such a withdrawal could have enormous consequences.

Short list of options

Yet Washington finds its options limited.

President Bush asserts longtime support for a “strong” dollar, and made that point again Sunday in a news conference in Japan with Prime Minister Yasuo Fukuda. “In terms of the dollar, the United States strongly believes – believes in a strong dollar policy and believes that the strength of our economy will be reflected in the dollar.”

But not once in his presidency has the U.S bought dollars on foreign exchange markets – called intervention – to help prop up the greenback. There’s no telling where the buck will stop these days, although for the past few weeks it seems to be in a holding pattern. Even as three Bush Treasury secretaries in a row spouted the strong-dollar mantra, the dollar kept tumbling against the euro, the pound, the yen, the Canadian dollar and most other major currencies.

The Federal Reserve could prop up the dollar by increasing interest rates under its control. Increased yields would make dollar-denominated investments more attractive to foreigners. But that could undercut the already anemic economic growth in a frail U.S. economy rocked by soaring fuel costs, falling home prices, rising unemployment, and the lowest reading of consumer confidence in 16 years.

The Fed must do a balancing act between keeping the domestic economy from going into recession and keeping inflation at bay.

Furthermore, no Fed likes to raise rates aggressively in a presidential election year. It seems more inclined to hold interest rates low for now to give financial markets time to recover from the housing meltdown and credit crunch. It did just that in its meeting on June 25, leaving a key short-term rate at 2%. The rate reached that level in April after a series of aggressive cuts that brought it down 3.25 percentage points since September. Those cuts helped ease the housing and credit crises — but drove the dollar further down.

In early June, Bush declared before his trip to Europe: “A strong dollar is in our nation’s interests. It is in the interests of the global economy.” That, plus a warning by Fed Chairman Ben Bernanke that the dollar’s weakness was contributing to U.S. inflation, seemed to temporarily break the dollar’s tumble. Presidents and Fed chairmen don’t usually talk directly about the dollar and exchange rates – leaving that up to the Treasury secretary – and international bankers and investors took note of the high-level attention.

Over the past few weeks, the dollar has remained relatively stable, although it took a dip after the Fed decided to leave rates unchanged. If the Fed moves to lift rates later this year, as some traders and investors anticipate, it could buttress the dollar and spur an exodus of speculators from the oil market.

The other main tool to move the dollar – intervention in currency markets by buying dollars and selling other currencies – is risky.

It would take great sums of money to make any difference. The foreign exchange market is the largest in the world, with over $1 trillion traded each day. Seeing the U.S. trying to prop up the greenback by buying dollars could be taken as a sign of desperation and possibly trigger a renewed round of selling.

Furthermore, there has been little encouragement for such a strategy from finance ministers from the Group of Eight wealthy democracies – Japan, Britain, Germany, France, Italy, Canada and Russia plus the U.S.

Leaders of the eight countries were to meet in Japan beginning Monday, but the falling dollar was not even on the formal agenda. It’s too touchy an issue, and the dollar’s relative stability over the past few weeks makes it easier for world leaders to steer clear. “People will be talking about it in the corridors,” said Reginald Dale, a senior fellow with the Center for Strategic and International Studies.

Treasury Secretary Henry Paulson has suggested that nothing is “off the table” including intervention. But Bush has made statements suggesting he intends to let market forces set exchange rates.

Far-reaching impact

The impact of the falling dollar is not always visible to the average consumer. Not like the big numbers on gas pumps that give stark evidence of price levels.

But imported goods are getting more expensive.

And American companies suddenly look cheap to acquisition-minded foreigners. Belgian-based InBev’s hostile bid for Anheuser-Busch is a recent example. If the takeover goes through, it might open the floodgates to other foreign takeovers of American companies.

Some of the dollar’s decline depends on hard-to-measure factors, like the psychology of foreign investors.

When the U.S. economy is weakening, many investors stay away. The slide of the dollar has coincided with a long period of relatively low interest rates.

And some of the decline in the dollar’s global role “is due to the foreign policy failures of the Bush administration, not just to recent economic developments and policies,” suggests Adam S. Posen, deputy director of the Peterson Institute for International Economics and a former economist at the Federal Reserve Bank of New York. In other words, some international investors unhappy with Bush’s policy on Iraq or toward other parts of the world might not wish to invest in American companies or buy U.S. bonds.

Still, he argues that the euro is unlikely to replace the dollar as the world’s main reserve currency, and that the euro may be at “a temporary peak of influence.”

David Wyss, chief economist at Standard & Poor’s in New York, says he envisions a day when the dollar and the euro will share billing as the world’s reserve currencies.

He predicts that the dollar will remain roughly at its present levels “for a couple years.” Still, he says, “We might not be done with this down leg.”

Another big problem for the dollar is that the European Central Bank is likely to hike rates while the Federal Reserve stands pat, giving euro-based investments a bigger yield advantage.

“I could see more downward pressure on the dollar, over the course of the summer, not dramatically, if the ECB does raise rates,” said Robert Dye, an economist with PNC Financial Services Group. “If it is one and done, pressure will be minimal. But if it’s an ongoing pattern of rate increases, there will be more substantial pressure.”

A euro now buys as much as $1.55 in the United States.

Paul Volcker, who headed the Federal Reserve from 1979-87, warned in April that the nation was in a dollar crisis, and that what is happening now reminds him of the early 1970s, when serious inflation erupted as economic growth stagnated.

Then, as now, a weak economy limited the Fed’s options. The result was a spiral of rising prices and wages – until the Fed, led by Volcker, suppressed double-digit inflation with huge interest rate increases that pushed the economy into a steep recession in 1982. He recently criticized the current Fed as defending the economy and the market, instead of defending the dollar. Volcker said that will make defending the greenback much harder later.

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~ by richart123 on July 7, 2008.

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