Facing up to the falling dollar

Don't panic just yet. But watch out for Washington's attempts to 'rescue' the dollar.

What do Venezuela's Hugo Chávez, Iran's Mahmoud Ahmadinejad, and rap mogul Jay-Z have in common? They've all recently dissed the US dollar. And for good reason. Seven years ago, a euro would set you back as little as 84 cents. Today, it takes a whopping $1.49 to buy a euro. The trend line with respect to other currencies is similarly negative.

The precipitous drop in the dollar's value has set off alarm bells around the globe. Will China dump its massive hoard of dollars? Will OPEC stop trading oil in greenbacks? Will Persian Gulf states break their peg to the dollar? How low will the dollar go?

The response to all of these concerns is this: Be afraid, but not very afraid. Yes, the dollar's fall makes Americans poorer. It also reflects concerns about the health of the US economy. But so long as policymakers refrain from greater protectionism, foolish regulations, and loose monetary policy, the US economy and currency won't become second-rate.

The consequences of the greenback's decline are serious but manageable. The causes are more worrisome.

Consequences

The worst consequence of a falling dollar is that it erodes America's terms of trade. The lower the dollar, the fewer the imports that Americans receive as payment for a given amount of exports. For example, if in 2004 Caterpillar received €500,000 for each bulldozer it sold to Europeans but today receives only €400,000 for the same bulldozer, clearly this American firm's ability to command European goods, services, or assets in exchange for selling its product has declined.

Americans might indeed export more as a result of the dollar's lower price, but they'll receive less value in return for each dollar's worth of exports. Workers are worse off whenever their earnings buy them fewer goods and services. Likewise, Americans collectively are worse off now that their exports bring them less value, and now that their currency buys them fewer foreign goods and services.

Another negative likely consequence is Congress "coming to the rescue" with more protectionist policies. Grabbing any excuse for protecting favored domestic industries from foreign competition, many in Congress will use the dollar's fall to "shield" the American economy from the "unfair" and "destructive" globalized economy. But a key reason for the dollar's traditionally high value is that America is the biggest piston in the global economic engine. Reducing America's participation in the global economy will "enrich" Americans in the same way that reducing a worker's participation in the labor market will enrich that worker.

Some observers worry that foreigners will sell their dollar-denominated holdings, causing a spike in US interest rates. Especially during this time of turmoil in the mortgage and credit markets, such a rate spike could cause further pain for homeowners because higher real interest rates are likely to depress housing prices further.

But the mere fact that foreigners hold lots of dollar-denominated assets is no reason to worry that these assets will suddenly be dumped. In a 2005 interview, Charlie Rose asked the late Milton Friedman if dollar dumping by foreigners would be destabilizing. Mr. Friedman pointed out the obvious: "Yes, it might. But the people who would lose by it would be the foreigners who held that and who dumped those dollars."

The fact is, foreigners have little incentive to inflict losses upon themselves by dumping dollars for the sake of destabilizing America's economy. If investors flee the dollar, they will do so only because a worsening of policies in Washington makes dollar-denominated assets less attractive.

A falling dollar will also tend to reduce America's trade deficit. Contrary to popular opinion, though, this result is nothing to cheer about.

Far from being a curse, a large US trade deficit signals that the American economy is structurally sound. The reason is that this "deficit" rises as foreigners increase their investments in the United States. Because investors generally do not pour their funds into assets whose expected returns are poor, a growing US trade deficit signals global optimism about the future of the American economy.

More important, a growing US trade deficit itself further improves US economic prospects by bringing to America more investments – more factories, more machines, more R&D, more worker training, more competition. And more capital invested in America raises the productivity of American workers. That, in turn, means higher real wages.

But now that the dollar is falling, US imports are declining and US exports are rising, shrinking the trade deficit.

Causes

When ordinary investors look for places to grow their money, they seek high returns and low risk. The same is true for powerful global investors. For decades, the dynamic US economy has been near the top of the global heap in terms of high returns and low risk. That's why so many smart investors tend to keep a lot of their money in US dollars, a condition that has kept the greenback's value high.

Today, the free-market conditions that helped created this ideal investing climate are under threat. Now that Democrats control the House and Senate, Congress is showing greater enthusiasm for protectionism and higher taxes. By 2009, Democrats may well control the White House, too. Investors generally believe "that government is best which governs least." From that perspective, partisan gridlock is desirable because it keeps excessive political interference in the economy at bay. But with Democrats in control, the antitrade, pro-tax, "don't just stand there, regulate" forces will be unleashed. Such a prospect is already weighing down the dollar.

The dollar's fall is further fueled by the Federal Reserve's looser monetary policy. Pumping more dollars into circulation makes it difficult for the greenback to hold its value against other currencies – especially as investor demand for dollars wanes. Even worse, to the extent that the dollar's slide is caused by a more inflationary policy, then even the boost in US exports is nullified.

With the US government increasingly prone (or, at least, widely believed to be prone) to adopt policies less friendly to investors, and with the Fed taking a more inflationary stance, demand for – and thus the price of – dollars understandably drops.

The good news

Not all is gloomy. The flip side of the dollar's drop is the corresponding rise in the value of many other currencies worldwide. The cause? More market-friendly policies that are making many economies around the world more attractive to investors.

With the European Central Bank keeping euro inflation in check, with Eastern European governments flattening their tax rates, and with India and China opening and growing, investors are responding positively. And that's good news for everyone because it means rising global output that will improve the living standards of nearly everyone living in the modern global economy.

These gains for Americans will occur only down the road. And whether these gains eventually outweigh the immediate detrimental consequences of a falling dollar depends largely on the policies pursued in Washington in the next few years.

The best scenario for Americans is for the Fed to become more hawkish on inflation and for Uncle Sam to resist protectionism and the urge to raise taxes and regulate in ways that are politically appealing but economically appalling. If that happens, the dollar will regain much of its lost value. Any value it does not make up will represent the promise of greater global output made possible by better policies pursued also by other governments around the globe.

But if America turns inward – if it reverts to the mistaken faith in protectionism, higher taxes, and command-and-control regulation – investors will continue to flee the US economy. They will do so in such numbers that, over time, America will become a second-rate economy with a second-rate standard of living. Then it won't be just America's enemies and rappers who'll dis the dollar.

• Donald J. Boudreaux is chairman of the economics department at George Mason University.