The Decline of the US Dollar - Essay Example

Decline of the US Dollar Order No.238739 September’08 Decline of the US dollar The U. S. dollar has been losing its value for the most part of the past six years or so, when compared to the three other major currencies of the world, the euro, the yen and the British pound. In fact it has reached historic lows. The questions on everyone’s lips today are why the value of the dollar is declining and will it fall even further. This paper will outline the causes for the decline of the dollar. A number of monetary and macroeconomic factors have combined to the decline of the dollar. Introduction The dollar, as we all know, plays a very central role in the global economy. The dollar has been the worlds reserve currency since World War II. Americans always thought their dollar as a world currency was welcome everywhere. However of late foreign creditors are taking a second look at it. Any paper currency is worth only what foreigners think it is worth. And today the foreigners do not think it is worth as much as it was before and seem to have a low opinion about it. Against the Euro, the dollar has lost more than a third of its value and similarly it has lost its value against the British pound too. After it reached its peak in 2000 the value of the dollar has fallen by more than 40 per cent. This has led to a demand for measures to stop further decline and reduce the current account deficit caused by it. In the words of Andy McSmith (2007), “The decline of the dollar, symbol of US global hegemony for the best part of a century, may have become so entrenched that some experts now fear it is irreversible.” Reasons A combination of factors that include government policies and investment flow from outside causes the rise and fall of the value of the currency of a country. Many economists attribute the dollar’s weakness over the past years to what they call the ‘twin deficits’ of the US economy, the fiscal and the current account. This meant that the U.S. was spending much more than its savings and deficits were met by a liberal inflow of foreign money. At present the outflow of currency in the US is less than the inflow. Again the current account deficit is also because American consumers are spending a high percentage of their income. This has caused an increase in imports which in turn has led to higher supply of dollars and there has been a resultant fall in its value. The difference between exports and imports affects balance of trade. The U.S. continues to import more than it exports, thereby increasing U.S.s demand for foreign currencies. When the current account deficit is high there is a strong downward pressure on the exchange rate. Consumers in the US are buying a huge amount of imports and as a result the country has to borrow to finance the trade and current-account deficits. The US has been reduced to borrowing from the rest of the world. The decline of the dollar can be attributed to many other reasons as well. Some of them are: 1. Lower US interest rates: One of the main reasons for the decline of the dollar is the difference between interest rates in the US and the interest rates in the other leading economies of the world.. US interest rates are at 2 per cent, a rock-bottom rate by international standards and had even reached a 45-year low of 1 per cent earlier. In 2007 the US cut down interest rates by 0.75% whereas the interest rates in the EU increased. From the end of 2000 to June 2003, the interest rates were cut 13 times, from 6.5% down to 1%. Alan Greenspan, president of the Federal Reserve, reduced interest rates to revive the economy. But this resulted in an indirect intervention in currency markets. In June, the Federal Reserve raised interest rates and after four hikes, rates have risen from 1% to 2%. Lower interest rates do not encourage savings. When compared to the rest of the world the savings are less in America. Hence there is less demand for the dollar. As interest rates are going up in other developed countries in order to control inflationary pressures, investing in those countries have become more attractive thereby reducing the demand and consequently the relative value of the US dollar. 2. Sub prime crisis In America. Falling house prices and an increase in the number of mortgage defaults has resulted in a credit crunch and a decline in the housing market in the US. A large numbers of people in the US who have taken home loans in 2005 and 2006 are still cushioned by the introductory interest rates.. However once these introductory offers run out, their interest payments on the loans will increase, setting off more defaults. The fall in housing prices is one of the causes of the slowdown in the economy. 3. Rising price of crude oil. The rising price of crude oil has created speculation and uncertainty. Oil reached an all new high due to political turmoil. Since America is hugely dependent on imported oil, any rise in oil price will erode American economy. 4. Market Confidence: With the decline of the dollar many investors are of the opinion that the dollar is no more a good investment and that the US dollar may lose its position as the world’s major reserve currency. 5. US Government Responses. The US government has not yet intervened to strengthen the dollar. A devaluation of the dollar may help reduce the US current account deficit. 6. Strength of the Euro and the Yen The Euro and Chinese Yen have been gaining power due to certain wise decisions and proper planning of economic resources. One more reason could be the money America has spent on overseas wars. Many are of the opinion that this money could have been utilized to improve infrastructure. Effects of the decline of the dollar The decline in the value of the dollar is affecting everyone and everything. On the upside of it, though the decline in the value of the dollar has hit consumers, companies in the US will become more competitive, which will in turn help them to make profits and also there will be an increase in the number of jobs available. However exporters in Europe and Asia have found it difficult to sell their products in the US market. International companies in America are facing uncertainty. On the other hand, U.S. exporters are experiencing a tremendous boom as their products have become cheaper abroad. As U.S. exports increase, small-business people are making profits. It has been reported that in 2006, about 239,000 U.S. small businesses were exporters. Since commodities like crops and metals are traded in dollars, their prices may have to be increased. Already there has been a boom in gold and oil after the decline of the dollar. American tourists may have to change and curb their tour plans as travel overseas is becoming more expensive. Many believe that the decline will benefit America. Aaron Daniels (2008) is of the opinion that “a weakening Dollar is actually a benefit to the US right now. With an economy on the brink of recession, a weak Dollar will increase US exports and tourism in the US by foreign tourists. Increased US production linked to the decline in the value of the Dollar abroad will translate into more jobs in the US.” Remedies “There is no rapid solution for an American economy that is not saving enough; (but) the reduction in the public-sector deficit, combined with a weaker dollar head my list of urgent macroeconomic remedies,” writes Roach of Morgan Stanley. (2004) Stephen L.of the same firm said the dollar has to make a downward adjustment, in order to bring the US deficit back into balance as quickly as possible. Conclusion Many arguments, most of them complex and somewhat devious are being put forth by economists to explain the decline of the dollar. But the simple fact is that the Americans are living beyond their means. Even the government has been doing what an average American has been doing. As American families pile up credit card debt and default mortgage loans, the government is piling up national debt. Inflation will increase if Americans do not reduce their oil consumption and consumption of foreign goods. As Kate Incontrera (2008) says “Most of the reasons for the declining dollar are like self-inflicted wounds by U.S. politicians and policymakers. We live in a nation whose policy discourages saving and long-term investment, especially in energy systems. And the culture, backed up by monetary policy, encourages over consumption” With all the hue and cry about its decline, today the dollar still rules proving all forecasts of it’s disappearing from centre stage false. This year, since the beginning of August, the dollar has made a comeback against other major currency. It is not certain that this rally will be sustained but its bounce back is certainly big news. One reason being attributed to this rally is the long overdue correction. As C. R. L. Narasimhan says, “While the U.S. economy has been battered by the financial crisis, other major economies seem to be suffering more.” The euro area economy has shrunk in the second quarter; The Bank of England has forecast a long period of stagnation for UK and Japan’s GDP has fallen. On the other hand, in the US the forecast for growth in the U.S. is clearly optimistic. Narasimhan further says,” the message is that in the era of globalization no country is spared the pain of a major financial crisis even if it had originated elsewhere. And currency movements are quick to latch on to economic fundamentals including GDP growth rates and inflation and expectations of them.” But Tom Fent (2004) warning holds true even today. He said “British Empire and the pound were shattered by two world wars and economic mismanagement. America has not yet reached that point, of course, but we ignore the lessons of history at our peril. Unless we put our economic house in order and stop living beyond our means, we could go the way of the British.” References 1. Daniels Aaron (2008), The Decline of the US Dollar: What Does It Mean? Retrieved from http://www.apdaniels.com/2008/03/09/the-decline-of-the-us-dollar-what-does-it-mean/ 2. Fenton Tom (2004), The Dollars Decline Does Matter, Retrieved from http://www.cbsnews.com/stories/2004/12/06/opinion/fenton/main659179.shtml 3. Incontrera Kate (2008), The Daily Reckoning, Retrieved from http://www.dailyreckoning.com.au/dol-decline/2008/07/22/lar 4. McSmith Andy (2007), The dollars decline: from symbol of hegemony to shunned currenc, The Independent, Retrieved from http://www.independent.co.uk/news/world/americas/the-dollars-decline-from-symbol-of-hegemony-to-shunned-currency-400715.html 5. Narasimhan C.L.R (2008), The dollar continues to reign supreme financial scene, The Hindu. Read More