Wednesday, November 16, 2005

Dollar Stability

Why contrary to popular wisdom the US dollar will rise in the long term.

The US is slowly being sold to foreigners who accept our dollars on exchange for their goods. They buy treasury notes, real estate, raw materials and US companies. They are happy to own US assets. The US is a politically secure country with low inflation and a high quality of life; it is a good place to live -- a safe country. When people look at the balance of trade, they apply the economic principle that in the long run the currency will adjust (fall) to bring the balance of trade back into equilibrium. That's because an imbalance in trade cannot last forever. Eventually Americans will be able to borrow no more from foreigners because eventually with continued borrowing and trade deficits we will have sold them a claim on everything we own in exchange for the goods they sold us and we consumed. Goods like TV's, cars, oil, lumber. We've given them claims like treasury bill and securitized mortgages, as well as direct title to property they buy here like office buildings and companies.

Our country is more geared towards consumption than investment. We consume large amounts of medical services, we consume through military expenditures, by government payments to the retired and disabled (although in theory their prior payments (social security and disability wage taxes should have funded the current expense), by farm subsidies, and government services like jail and welfare, police and fire departments, snow plowing of streets, etc. We invest publicly in road construction and privately in house construction and renovation. We have put a great deal of our wealth (and of the money we've borrowed) into house construction and after all that's a good thing because no foreigner is going to take that house and walk away with it. It makes our own country more desirable. They may however buy the mortgage and collect the interest each month.

It's a bad thing because, while making the neighborhood, and the country, a nicer place, a fixed up house does not produce any additional goods by virtue of its creation like for instance the expansion of a printing press would print more newspapers that would then be sold.

So what, you ask, does all this have to do the US dollar going up? Doesn't it sound like it will go down?

Yes, actually many believe that the dollar will fall because foreigners will stop wanting to hold US treasury bills and other assets. As Americans continue to borrow, the foreigners will want higher interest rates and not seeing them as high as they'd like, they will sell more of their dollars than they otherwise would have, causing the price of dollars to fall relative to other currencies. After the dollar falls, the foreign goods will rise in price, Americans will buy less of them and eventually the trade deficit will become smaller and smaller, eventually turning into a small surplus each year. This scenario, widely accepted by economists is certainly a definite possibility. But I think the imbalances will have a different result.

Foreigners like investing in the US -- I don't think that will change. As you look around the world, asset prices (i.e., real estate) are sky-high almost everywhere. There is political risk, risk of wars, risk of epidemics, risk of inflation. These risks are much lower in the US than most other countries. Many foreigners want to move here to live; owning a big chunk of the country may be an acceptable alternative to them.

The basic premise behind the idea that the dollar will fall to restore the trade balance is that foreigners will decide first that they don't want to fund ever rising trade deficits with huge loans. Borrowing by government and individuals clearly funds the trade deficit, yet I believe that it will work out that foreign demand for US assets is greater than US demand for foreign goods. That the tipping point for the US dollar will be that Americans, fully satiated, stop importing quite so much, start exporting a little more, expand domestic capacity in a continued shift to services, decide to reduce government deficits, and see the dollar rise. Of course a higher US dollar will make foreign goods appear even cheaper, but Americans will not buy more as they have already been buying all they need. Instead they will shift after this long orgy of consumption, shocked by high gasoline and electricity bill and continuing mortgage payments, into a culture of more measured consumption.