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Why is the U.S. Dollar becoming the 98lb weakling?


by: Jon Aldrich

You cannot go very far these days without hearing talk about the steady weakening of the U.S. dollar.

U.S. Dollar - actual_size

What exactly does it mean to have a weaker dollar? A currency can rise or fall in value in comparison to foreign currencies. When the value of the dollar decreases against other currencies, those holding dollars will get fewer euros, pounds, yen or other currencies in exchange for their dollars. One effect of this has been to make travel abroad a lot more expensive than it was when the dollar was stronger. A weaker dollar does, however, make our products cheaper to foreign buyers. We will discuss the ramifications of this later.

So what causes a weak dollar? It can be attributed to a several factors, but right now the primary reasons are likely the huge amount of dollars being printed combined with out of control spending by the U.S. government. Another reason could be the lack of confidence that foreign investors have in the U.S. due to our economic troubles, never ending bailouts, high unemployment and expanding trade deficits.

USD index-Nov-17-2009

Still another reason for the declining dollar could be the perception by other countries, such as China, that the US is trying to inflate its way out of its massive debt load. What does this mean? It means that if the U.S. follows a policy of printing money and trying to create inflation, the real level of debt will decrease. This allows households and banks to deleverage their huge debt loads faster and less painfully. The problem with this policy is that no country in history has ever successfully inflated its way out of its debt without creating hyper-inflation. By introducing inflation, there is a risk of triggering serious problems in the bond markets accompanied by a pull out by foreign investors. This would lead to higher interest rates, further fanning the flames of inflation

Finally, investors are selling U.S. dollars and using the proceeds to buy stocks of developed and emerging countries and commodities such as oil and gold. This is a version of what is called the “carry trade”, where you borrow in the currency of a low interest country (such as the U.S.) and invest that money in the assets of counries that have a higher rate of return. For many years this was done with the Japanese Yen. In 2009 the U.S. dollar is the currency of choice for the carry trade.