Home » U.S. Economy » The Decline of the Dollar: An Explanatory View

The Decline of the Dollar: An Explanatory View


The US economy has been depressed with the prevailing notion that the market value of the US dollar has been viewed as dismal for a number of years now.  Starting in 2002 when the exchange rate for the dollar reached its last peak at 112.1853(DXY: IND) against other major currencies, the dollar has steadily declined ever since (Federal Reserve); as of the last trading day of November 2010 the dollar currently stands at 84.0201(DXY: IND).

The wealth and stability of a nation depend on strong financial markets, stable monetary and fiscal policies and, not surprisingly, strong currency as well.  Keys factors- such as the budget deficit, a reduction in foreign investors holding US currency in reserves, and the current account deficit, along with our growing dependence on foreign credit- are the major contributors for the decline of the dollar.  And while there are other sub-factors in deed, only the main driving forces will be discussed in detail for the sake of this report.

In 2003 the Federal Reserve released its annual report on Monetary Policy and Economic Developments where it announced that the state of the economy at that time resulted in an “unusually rapid productivity growth that boosted household incomes” which led to increased spending/demand while businesses were able to keep costs low.  Contrarily to US households increased spending, the economy’s productivity performance was also associated with businesses becoming concerned with international matters such as the increase in energy and oil prices along with war-time events and “once again became hesitant to spend and to hire, and both manufacturing output and private payrolls began to decline.”

An important term to mention from the above paragraph is: productivity performance. A nation’s wealth is measured through its ability to effectively produce goods and services at one given period.  Exactly how the US economy is measured is through a system that estimates national economic data.  This estimation is known as the gross domestic product (GDP).  The GDP is one of the most influential and widely used (and most often criticized) economic mechanisms that greatly affect financial markets. The GDP measures the total market value (all goods and services produced, exports, and private and public spending); when adjusted for imports and inflation, then the “real” GDP figure is composed.  In 2002, according to the Economic Research Service of the US Department of Agriculture, real GDP was $11,553.00B with a growth rate of 3.28 percent.  Presently, real GDP is $13,189.73B with a growth rate of 3.5 percent (primary figures estimated for 2010). To put this in perspective: Reports released back in 2004 gave the first real long-term economic indicators in relation to the value of the dollar, and its consequences thereof, against other major currencies.  It was announced that “its value ha[d] dropped more than 40 percent against the European currency since 2002.”  Growing concerns about the investment implications –for US and foreign businesses alike- led to investors pulling back from investing in US financial markets. One of the major factors in US economic stability is the federal budget.  The federal budget, as defined by the Center on Budget and Policy Priorities, a national public policy organization, “outlines the U.S. government’s spending plans for the coming fiscal year and how it plans to pay for that spending.”

Furthermore, The Congressional Budget Act of 1974 was established as a means to develop tax and spending legislation as guided “by a set of specific procedures laid out in the [act].”  These specific procedures entails that Congress develops an annual budget resolution by “setting aggregate limits on spending and targets for federal revenue.  The limits set by the budget resolution, along with a companion “pay-as-you-go” rule;” some, in fact, have attested to the shortcomings of this policy as Congress is presently working on its revision. The federal budget measures total government (national, state and local) spending against total monies (private) received.  According to the Office of Management and Budget, the federal managing office of the “budget” created during the 1974 act, the federal government has been spending more than it’s received consistently since 1970- with a brief surplus from 1998-2001.

Be it as it may, when measured against GDP, the federal budget deficit has been on average about 20 percent relative to the economy as a whole.  In fact, historical data shows that budget surpluses have been scarce.  The US Department of Treasury states that, “Beginning in 1929 and up until 1969, the budget was in surplus for a total of nine years, and during that time was never in surplus for more than three years in a row.”  Additionally, against the imperative argument that the federal deficit will cause inflation and interest rates to arise, studies show that “it is changes in the surplus or deficit that can affect the rate of economic growth.” And it “…depends on the size of the deficit, and of the interest payment on the outstanding debt.  A rising debt-to-GDP ratio eventually poses the risk of accelerating inflation.”  This deficit to GDP comparison reveals a “truer” state of the economy by filtering out “changes due to variations”.  However, it must also be pointed out that, “In the long run, the relationship between the growth rate of the federal debt and the overall rate of economic growth is critical to financial stability.” When a currency is held by another country in order for that country to conduct international transactions more smoothly the currency being used as called a reserve.  Since World War II, the US has had the largest amount of reserves held by other nations.  Along with currency reserves are foreign exchange reserves, which are assets in foreign currency stocks, and the occasional gold standard, that allow countries to align their currencies to other currencies through a system called pegging in order to keep its currency stable and reduce any sudden economic alarms.  The information contained by the International Monetary Fund for the official reserves of several nations (in its COFER database) consists of the monetary authorities’ claims on nonresidents in the form of:

  • foreign banknotes,
  • bank deposits,
  • treasury bills,
  • short- and long-term government securities, and
  • other claims usable in the event of balance of payments needs.

In 2002, there were over $2.4 trillion in total foreign exchange reserves with the United States accounting for over $1.2 trillion of those reserves and the euro reaching in second at just over $427 billion.  Presently, total world foreign exchange reserves have topped $8 trillion in assets; the US has a 2010 estimate of $2.83 trillion and the eurozone nation’s account for an estimate of $1.25 trillion according to Global Finance Magazine. The composition of those who hold reserves are both public (government or ‘official’) and private (individual investors).  From 1997 to 2000, US assets held by foreign private and official investors saw a surge in net private inflows, as stated by the Congressional Budget Office.  But, “In 2001, however, private foreign demand for U.S. assets began to moderate. By 2004, net private capital inflows had fallen to just $186 billion from a high of $445 billion in 2000.” Yet, foreign governments had instead, “substantially increased their official purchases of US assets in 2002.” Concurringly, as noted by Global Finance, “In 2000, reserves held by advanced economies almost doubled those reserves held by emerging and developing economies—at $1.2 trillion and $0.7 trillion, respectively. By the first quarter of 2010 these figures had reversed, with emerging and developing economies holding almost double those of advanced economies in the COFER database—at $5.5 trillion and $2.8 trillion, respectively.” A shift began to occur among private and official holders.  Although, it should be said that this composition reflected a shift in who’s holding the reserves rather a shift in investor preferences.  This change occurred predominately because to the exchange value of the US dollar.

A declining market value boosts the supply of US assets which in turn decreases US imports. While private foreign investors were relaxing their holds on US currency reserves, foreign governments were increasing their stance on reserving US dollars. As stated by the Bureau of Economic Analysis, a division of the US Department of Commerce, “Net private foreign purchases of U.S. Treasury securities were $65.0 billion in the third quarter [2010], down from $101.3 billion in the second.”  While, “Foreign official assets in the United States increased $141.6 billion in the third quarter, following an increase of $43.6 billion in the second.”  This development follows the previous statement on how emerging and developing economies increased US reserves and the notion that private investors were reducing their holdings. As the chart below indicates, from 2001 to 2009 private and official inflows dramatically changed.

       2001      2002      2003       2004      2005      2006     2007   2008     2009 
Net Off'l
116,379 267,382 687,874  985,975 585,443 1,124,904 849,372 1,690,804  1,452,211
Inflows ___________________________________________________________________
Net Prvt.
 570,322 486,935 386,501  634,368  703,771  870,394 932,794 352,442  170,179
Inflows

Source: Bureau of Economic Analysis, U.S. International Transactions Accounts Data

As a result of the United States having more foreign capital inflow than domestic capital outflow, the US has run a current account deficit.  The current account balance represents a country’s current transactions on a global scale. As it presently stands, “The U.S. current-account deficit… increased to $127.2 billion (preliminary) in the third quarter of 2010, from $123.2 billion (revised) in the second quarter of 2010.  The increase was the fifth consecutive quarterly increase since the deficit of $84.4 billion in the second quarter of 2009, which was the smallest deficit since the third quarter of 1999,” according to the Bureau of Economic Analysis. Two major categories that affect the current account are the foreign direct and portfolio private investments and the government investments.  Sales of US assets are rapidly growing among officials- fueling the deficit even further.  Moreover, the CBO pointed out that “Almost all official purchases of US assets were made by a handful of Asian governments,” with China-in particular- leading the way.

The United States has welcomed China’s investment of its excess foreign reserves in U.S. Treasury bills, which has effectively helped to finance the U.S. current account deficit – the result of a low savings rate and government spending that far exceeds its income. This massive “loan” from China has effectively helped the U.S. government to do everything from waging wars in Iraq and Afghanistan, to paying Congressional salaries (including those of politicians criticizing China), to rebuilding roads in New Orleans, and writing Social Security and Medicare checks. In turn, China has had a safe place to park its excess dollars. U.S./China Media Brief, UCLA Asian American Studies Center

Beginning in 1994 when China pegged its currency to the US dollar, its foreign exchange reserves have since then reached $2.65 trillion.  Currently, nearly 70 percent of China’s reserves are in US-backed government securities.  The Chinese government pursues this method in order to keep the yuan (Chinese currency) low to compete against other nations manufacturing productivity, such as the United States.  On the other hand, the US allows this to go on due to China’s continual purchases of US assets, which has now surpassed $907 billion with Japan second at $877 billion.

The Chinese government, however, has slightly pulled back.  They held at one point as much as $945 billion. As an emerging economy, China has the fastest growing market the world has ever seen.  “The yuan is strengthening at the fastest pace in five years, advancing 1.7 percent [in September, 2010] against the dollar after the end of an almost two-year peg in June,”  according to Bloomberg.  Thanks to China, the global emerging markets of India, Brazil, and Russia, are now rivaling the richer, advanced nations.   Due to its struggling economy, the United States ranks second in the world behind the European Union in terms of GDP with China in third place, according to the CIA World Factbook.

Further controversy arose when the IMF recently approved China to become “the third-strongest voice in the organization.”  In a November 5th report by Bloomberg it stated that, “the IMF agreed to shift more than 6 percent of voting rights to what officials called “dynamic” developing countries. That would give more say to nations such as Brazil and South Korea, while decreasing the clout of European members including Belgium and Germany. “Advanced” European countries are also set to give up two seats on the board under the package.”

The outlook on the US dollar continues to be dreary.  As we enter a new year many are predicting its value will persist in a downward trend.  Nations like China are now looking for ways to diversify its excess cash flow by dumping its US currency into other flourishing, emerging markets.  However, those who support the sentiment that the dollar remains strong say that, “The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”  More notably, investors still do view the United States as the safest form of allocating their assets. There are many arguments on the resolutions to the decline of the US dollar.  Many include: Increasing the savings rate for US residents in order to save more and spend less, to “force” China to reduce its exchange rate management of pumping its US currency reserves back into the Unites States which enlarges the trade and current account deficits even further, and that the Federal Reserve- on behalf of Congress- must change its monetary policy of a slow and steady price value adjustment along with the federal budgets aggregate spending fiscal policy. The US economy faces many challenges with a high unemployment rate, a failing housing market, a financial crisis, and trade imbalances.  But, as US Treasury Secretary Timothy F. Geithner said at an October G-20 Press Conference, “If the world is going to be able to grow at a strong, sustainable pace in the future, if we are going to be successful in building a more stable global financial system, and if we are going to be able to continue to expand opportunities for trade and preserve an open trading system, then we need to work to achieve more balance in the pattern of global growth as we recover from the crisis.”

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