A Stitch in Haste

Maybe my blogroll is just too small, but there's been a surprising dearth of commentary about the recent rather precipitous decline in the U.S. dollar:


(Click to enlarge.)

I'll be the first to admit that international finance is among the hardest topics in economics. So let's keep it simple: like everything else it boils down to supply and demand -- especially demand.

Dollars are (basically) only useful for two purposes: to buy American goods or to buy American investments. If people (mostly foreigners) don't want as many dollars (which is precisely what a falling dollar means), then it must be for either (or both) of two reasons: people no longer want as much American goods, or they no longer want as much American investments. Or both.

Now since there is no reason to suspect that foreigners want fewer American goods*, the far more likely explanation is that they no longer find American investments as attractive as they have in the recent past. But that doesn't make much sense either, given that the yield curve has also risen sharply recently -- returns on American bonds are going up, not down, which ought to entice even more foreign demand for dollars with which to buy those increasingly attractive bonds.

Ah, but there's the rub -- and the resolution of the paradox. Investors make decisions based not only on where interest rates are, but also on where they're going. Why buy a dollar-denominated bond that yields 5% today if you think it will yield 6% tomorrow? If you think that U.S. interest rates are going up, then you keep your powder dry and sit on the sidelines until you think that interest rates have peaked. Which in turn means that you have no urgent need for dollars. Which in turn means that the dollar loses value.

This is of course is a huge problem for the U.S., since no rational investor has any reason to think that interest rates won't stop going up, especially given the abhorrent fiscal recklessness of the federal government.** Government deficits drive up interest rates, and as ever more and ever larger deficits are on the horizon, the more likely that interest rates will continue to rise, and the more likely that foreigners will have diminished demand for dollars today.

This is of course only a small part of the mechanics of exchange rates -- inflation also plays a huge role. But the point is that the assertion that the federal government can spend ever more money it doesn't have, with impunity, is a dangerous fallacy. Especially when the Bush apologists relentlessly insist that the economy is in fact "picture perfect" and that budget deficits (and trade deficits) "don't matter."

They matter, and they exact a price. And we are starting to pay that price -- through higher interest rates, and now with a weakened dollar too.

And things will get worse, much worse, before they get better.

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*Decreased demand by foreigners for American goods could result from deteriorating incomes abroad, or the expectation of deflation in the U.S. But neither phenomenon is particularly present currently.

**And state & local governments too. Not to mention over-leveraged real estate speculators and increasingly indebted consumers.