One aspect of the growing deficit and debt problem that I've noted that I was not addressed is it's impact on the value of the U.S. dollar on world currency markets. I want to address this issue here.
One very provocative commentary from the Financial Times of London concisely lays out the problem. World currency markets are another kind of market where the value of the U.S. dollar in terms of any other world currency is determined by the demand for and the supply of dollars on world markets. Much the same points were made today by Yale Finance professor Jeffrey Garten. An extended article on these dynamics written by Doug Noland from The Asia Times is available here. One of Doug Noland's more unsettling passages is his view about what's needed from the U.S. "It is my thesis that there is no alternative other than a major transformation of the underlying structure of the US economy. In simplest terms, we must produce much more, consume much less and do it with a lot less credit creation. "
The underlying gist is that our debt levels cannot be reduced through spending cuts or tax hikes since the magnitudes required are politically untenable. Given the political gridlock we're in, he's probably right. Therefore, the only way left to reduce the U.S. federal debt is to decrease the dollar's value. We do this by lowering the value of the dollar on world markets. Since the dollar's value is not fixed, but rather is determined by the market itself, we have to use tools to 'influence' the dollar's value. (NOTE: Reducing the dollar's value on world markets is different from the term 'deflation' used to describe the situation when the price level in the economy drops).
When countries want to hold fewer dollars, they put them up for sale. This increases the supply of dollars on world markets. Without a counter-veiling increase in the demand for dollars, the dollar's value falls relative to other currencies. While the linked writings above assume that foreign holders of U.S. dollars will release some of those dollars, I have a question about how they go about doing that knowing that doing so will likely result in a drop in the value of their remaining dollar holding. The U.S. government can increase dollars on world markets not by "printing" money. Rather, they buy U.S. government securities from holders like banks and large investors and that puts more U.S. dollars in circulation and thereby lowers the dollar's value of world currency markets.
How does a falling dollar help reduce the Federal debt? As the dollar weakens in value, products made in the U.S. are cheaper overseas, more production happens here, people overseas buy more U.S products, they travel to America more, and they buy American assets. In turn, GDP (the measure of overall economic activity) rises, and more tax revenue is earned. However, the cost of imports to the U.S. go up for Americans. This will also tend to increase consumption here of domestically produced goods since we will tend to substitute American made goods for imported goods, another incentive to greater domestic economic activity (GDP).
What about the price of gas? Ouch! RIght now, the price of oil is denominated in U.S. dollars on world commodity markets. This means that if the oil exporting country wants the same buying power of U.S. dollars after the dollar falls in value, they increase the price of oil. As a result, the price of oil, and therefore, the price of EVERYTHING made from it, goes up in the U.S. This is basically what happened when gas was over $4 per gallon about 16 months ago. The U.S. dollar has been the world's reserve currency. This means that the U.S. dollar has been the currency other's flock to in periods of crisis. This is what's been happening and that's helped keep us afloat during this recession. That all is beginning to change.
The political optics of all this will be interesting. WalMart's been doing well during the recession, and a drop in the dollar's value will really hit them. They'd have to either raise prices or take a bigger hit to their bottom line as the cost of goods they import from China rise with the dollar's fall. (They import the vast majority of their product from China). Also, how will such a strategy play out among other governments and bankers in other Industrialized countries? We do know that the domestic political optics are going to put increasing pressure on the Administration to take action for political reasons, I believe.
What to do? What's the timing of all this? Good question about the timing. In general, the cost of taking that overseas trip, or buying that foreign made product will only go up. Personally, I have 15 percent of my retirement invested in foreign stocks indexes and only 5 percent in U.S. stock indexes. Talk to your investment analyst who knows about international currency markets and commodity markets. Buy that Prius sooner rather than later (or other high mileage import), begin to figure out how to reduce your 'oil footprint.' Maybe look at parking some U.S. dollars in some foreign currency or at least foreign stocks (basically what I did when I invested in foreign stock indexes).
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