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Ramifications of a Dollar Decline

With the dollar recently hitting lows against many major currencies, I’ve seen a great deal of activity in the financial press on the subject. Recently I had the opportunity to comment about how investing in commodities would be attractive in a severe situation in a BusinessWeek article, Ways to Weather a Weaker Dollar by Marc Hogan.

Although currency issues are an extremely difficult to predict, personally I do believe that we are exiting a strong dollar environment to a more neutral dollar. What are the ramifications of a declining dollar? Earlier this year I wrote an entry on the subject and discussed the impact depending on the severity of the decline. Here is what I had to say back in January:

Ramifications of a Dollar Crash

Unless you run a business that is heavily reliant on international trade or if you live or travel overseas, currency issues don't really fly on most people's radar screens. But as time passes, more and more we are becoming a global society and the events of the world are affecting our daily lives. With that, I think everyone would want to hear what Bernard Lietaer has to say.

Lietaer is the author of The Future of Money and is one of the individuals credited for creating the Euro currency. He was the keynote speaker at the Financial Planning Associations Retreat in Tampa, Florida earlier this year. In his discussion, Lietaer discussed four mega-trends that will come about and need to be resolved over the next fifteen years. One was the aging population, another involved the global economy growing faster than job growth and technology taking up the slack, the third was the climate change and the loss of biodiversity.

But it was the last mega-trend that got the audience on the edge of their seats. He predicted that there was a 50% chance the dollar would collapse and that the U.S. government would take actions that would remove the dollar as the world's reserve currency, creating a vacuum in the global economy.

Leitaer cited several different factors that could influence this type of crash. The U.S. and its "twin deficits" involving our trade imbalance along with our federal budget deficit was an obvious issue. He also cited that the stability of the U.S. dollar is not in the hands of the U.S. Federal Reserve, but in foreign hands. He stated, "Every single working day, the world has to invest 2.8 billion dollars in the United States to keep the system going; that represents 80% of global savings." And as an example, he discussed how China with its billions of Treasury debt in reserves, could potentially use this as a bargaining chip to keep the world from interfering with its ongoing friction with separatist Taiwan; threatening to dump its reserves on the market and cause a crash. Leitaer also mentioned that back in the 70's, Kissinger made a pact with the royal family of Saudi Arabia to make the global oil trade denominated only in dollars. No matter if you were China, France, or Japan, if you want to buy oil you have to do this in dollars. He warned, "This cannot go on forever" because of the potential for regime change and waning influence of Saudi Arabia on the other OPEC nations. Finally, the world could simply lose faith in the U.S. economy. As a result of the crash, he predicted the U.S. would experience a large decrease in consumption, a potentially higher income tax structure, and much higher interest rates.

Now personally, I'm always a bit of a skeptic when it comes to "doom and gloom" scenarios. I feel that most catastrophic economic crisis arise from things that aren't anticipated. But as a financial planner, my responsibility does entail contingency planning and how these contingencies could affect my client's livelihoods and portfolios. What would happen if we actually experienced a "dollar crash"? I'll discuss this later this week. Earlier this week, I discussed what Bernard Lietaer theorized could cause a crash in the U.S. dollar. What would happen if the dollar did actually plunge in value? I think there are several paths that this can take:

The Soft Landing: This scenario doesn't involve any dramatic drop off in the dollar; rather the dollar would slowly depreciate to a more balanced level. Imported goods (particularly from the Far East) would be more costly for us to purchase. Meanwhile our export economy would slowly revitalize since our goods will become cheaper and be more in demand with the increased wealth that the people living in developing nations are beginning to experience. Our trade balance would slowly disappear and higher tax revenues would rebalance the deficit. The threat of outsourcing would slowly turn around. The domestic stock market would appreciate as a result, in particular large multinational corporations and those within the manufacturing sector. Smaller (non-multinational) foreign stocks would also do well along with bonds denominated in foreign currency. Larger, dollar reliant multi-national foreign companies wouldn't fare as well.

The Hard Landing: This would happen when one event creates a chain of events, leading to panic and crash in the financial markets. For instance, a geopolitical event such as China invading Taiwan could trigger this. Or sudden changes in the market makes a hedge fund go under; leaving exponential obligations and a huge sell off of assets around the world to fill the gap. Commodities, long term interest rates, and inflation would take off. Ironically, the rust belt would come alive and become a boom area of the country with its cheap manufacturing capability and attractive asset prices to overseas buyers. The domestic stock market would crash along with the housing market. Seeking safety, short term debt and money market accounts would be earning close to nothing. Foreign stocks and foreign denominated bonds would do exceptionally well in light of the immediate event. Eventually, the results will be the same within the soft landing, but this scenario would be accompanied by more extreme market conditions, panic, capitulation and pain that would amplify the situation.

Worst Case: This is what Lietaur suggested. This is where the U.S. government takes action that creates artificial market conditions with regulations and reneges on its obligations to its debt holders around the world. Essentially there would be two dollar's, a foreign and a domestic dollar. It would spark a new era of global protectionalism and currency restriction. The global economy and financial markets would in a prolonged recession or depression and the U.S. would experience higher interest rates, deficits, taxes, and the real estate market would bust. Wal-Mart wouldn't have anything on their shelves because all the foreign goods would be too expensive to buy.

Overall, the export nations of the Far East will continue to buy our Treasuries as long as they see their return on investment (in the form of jobs and economic growth) exceed the cost of holding these bonds at historically low yields. Remember, they have a vested interest in keeping their export machines going. Eventually the economic disparity will have to rebalance with the dollar depreciating. But barring any irrational event, the soft landing is what I expect and hope for. Now, I wouldn't go to extremes and start storing gold bars in your basement. By conducting a scenario analysis such as this, it at least allows you to be ready if the unexpected happens. And it allows you to approach things in a rational manner. But this analysis does shed light on the importance of having an investment strategy that is global in nature.

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