Will the U.S. Dollar continue to fall?

Because global financial imbalances are the greatest in history—as evidenced by the U.S. current account (trade) deficit—and we expect consistent fiscal and monetary policies, we do not foresee a change in the structural issues that have contributed to the weakening dollar. We cannot predict with certainty that the dollar will in fact decline; however, we present an overview of economic forces permitting you to assess whether a basket of hard currencies, such as provided through the Merk Hard Currency Fund, is a valuable diversification element to your existing portfolio to protect yourself against a further decline in the U.S. dollar.

In 2007, the trade and current account deficits continued to reach levels in excess of 5% of gross domestic product (GDP). Many economists do not believe this is sustainable. The question is how the large current account deficit will be reduced. The primary options typically discussed include an increase in domestic savings, an increase in foreign consumption, or a lower U.S. dollar.

Domestic savings

The U.S. household savings rate remained negative (-1.0%) in 2006, compared to Chinese households that save over 30%. The U.S. is a consumption machine, with about 70% of GDP due to consumer spending, up from about 50% in the early 1990s. An increase in savings would mean a decrease in consumption, i.e. a recession, unless real incomes are going to rise substantially.

Can we expect real incomes to rise? Consider this: U.S. corporations have little pricing power because the market is flooded with inexpensive imports from Asia, and because U.S. consumers are heavily in debt. Conversely, U.S. corporations face high raw material prices as U.S. and Asian policies cause global over-production: Asia causes overproduction by subsidizing their exchange rates; the U.S. is contributing to overproduction through monetary (low interest rates) and fiscal (lower taxes) policies. U.S. corporations are left with little choice but to accelerate their outsourcing, so that they can reduce their remaining variable cost: labor. This explains why we have had relatively disappointing employment growth while GDP growth has been respectable. While wage pressures are going to increase, we do not see how substantial real income growth will occur to reduce the current account deficit.

Instead, the current account deficit could be reduced through a tax on consumption, e.g. through a national sales tax. One has to watch political developments, but a national sales tax is not popular with voters, or with businesses, or with municipalities.

Will social security reform increase national savings? At this stage, social security reform is facing an uphill battle, and even if one were to introduce true forced savings accounts, Federal Reserve Chairman Alan Greenspan has urged a slow introduction over many years. As far as such programs’ impact on savings is concerned, we are concerned that politicians would likely take some of the many opportunities to water down any serious proposal. We believe that the lack of a resolution on social security will contribute to a weakening dollar, as it is the politically most acceptable valve to reduce retirees’ benefits: a lower dollar may lead to a reduction in purchasing power, especially if the consumer price index (“CPI”) to which pensions are coupled do not fully reflect the increased cost of living.

Increase in foreign consumption

Policy makers in the U.S. would love to have the trade deficit adjust by an increase in foreign consumption; this would be the most benign way to unwind the global imbalances. The world economy continues to be highly dependent on U.S. consumer spending. Even as the U.S. economy slows down and spending in the rest of the world appears to be more robust, any recession in the U.S. is likely to pull down worldwide economic growth. There may be a time when intra-Asian trade and European growth can offset an economic downturn in the U.S., but that won't be anytinme soon.

Even as consumption in the rest of the world picks up, it is unclear how much of that growth will be derived from trade with the U.S.

Lower dollar

Currency devaluation tends to be associated with significant trade and current account deficits, but a lower currency doesn’t fix the imbalance. We saw this in late 2003 and early 2004, when despite a lower U.S. dollar, we had higher trade deficits. We believe that the weight on the dollar will not go away unless structural changes take place that will increase domestic savings and/or lower domestic consumption.

Consistency in policies

Although you may agree or disagree with policies of the Bush administration, most of us would agree that they have been very consistent. With Bush re-elected, we believe we will see relatively consistent policies. Bush has made it very clear that he likes to see growth and encouraged Congress to enact numerous tax cuts. Bush is not known for vetoing spending bills. He has pledged to “cut the [budget] deficit in half,” but only as a percentage of GDP with optimistic GDP growth and associated tax revenue assumptions. Just as we do not believe real incomes are going to rise significantly in this environment, we do not see tax revenue reach the levels forecast.

With Ben Bernanke succeeding Alan Greenspan as Chairman of the Federal Reserve, consistency in monetary policy is emphasized. Bernanke is known for his studies on the Great Depression; he is expected to be a "reflationist," someone who is expected to add liquidity to the markets when there is a threat of a downward spiral. The alternative, driving the country intentionally into recession to correct the current account deficit is not a politically attractive option.

Higher investment rates

Won’t higher interest rates increase savings? Because the U.S. consumer has more debt than ever before, the U.S. economy has become much more sensitive to changes in interest rates. Also, “old-economy” companies, notably General Motors, are struggling with pension and health care costs. Higher investment rates cause a significant threat to the U.S. housing market; given that consumers have financed their spending by extracting equity from their rising home values, even a stagnant housing market could induce a recession. It is unclear whether foreigners will be as willing to finance U.S. deficits by buying dollars if the U.S. economy slows.

As of late 2005, the U.S. is paying more in interest on its obligations to overseas investors than it receives in interest from its own investments abroad. As a result, higher interest rates increase the out flow of U.S. dollars—a relationship more typically associated with third world countries.

Next: How can I protect myself from a falling U.S. Dollar?