Picture of the Day: The Falling Dollar

Source: The Economist

This graphic from The Economist shows the fall of the Dollar (though note the recent fairly wide fluctuations).  I am glad my vacationing this summer is all in the US.  

By the way read the blog post linked to above about whether it is a matter of concern.  In my view it is not, it is part of the natural process of restoring equilibrium in world markets and the fact that this can happen to our national currency is a very good thing - it allows us to avoid the fate of Greece, for example, who would dearly love to have a declining currency right about now.

Econ 101: Exchange Rates

What determines the exchange rate? The simplest answer is supply and demand. Suppose you are sitting in England and have some savings in pounds and want to buy an asset in the US. To do so, you must sell your pounds for dollars because US based assets are priced in US dollars. This raises the demand for dollars and increases the supply of pounds - leading to an increase in the exchange rate between dollars and pounds. It now takes more pounds to buy dollars than it did before.

The New York Times has a nice article on the rising dollar. In it the author stresses the flight to safety - foreigners are snapping up US Treasuries. This is good for the government, because it keeps the cost of borrowing money low. But the rising dollar is bad for US exporters (and Oregon is one of the states most dependant on exports) because it raises the price of US goods abroad. So people and businesses from all over the world that are worried about loaning money to just about anyone, will still loan to the US government because it has the lowest risk of default of any entity out there. Since it takes dollars to buy treasuries, this raises the demand for dollars and increases the supply of just about every other currency. Voila, a rising dollar.

But it is not just the demand for US treasuries that is causing an appreciation in the dollar (though surely it explains most of the rise), there are also some other anecdotal snippets, like this story about foreigners snapping up houses in Detroit. If Australians and Brits are coming over here to but property, they are bringing with them their own currencies and will have to convert them to actually make a purchase which reinforces the appreciation of the dollar against those currencies. 

Crisis-o-nomics: Gold, Inflation and the US Dollar

While I was in Brazil, a former student sent me an e-mail with this question (sorry for taking so long to answer it):

"I'm curious what your opinion or knowledge is of currency commodities like gold and silver in inflationary or deflationary periods. Does gold or silver really hedge against the risk of inflation by giving similar purchasing power over time while a paper currency is losing purchasing power over time? I've been thinking over some issues revolving around these ideas a lot in light of our current economic situation. It seems as if there is a possibility for some high inflation in the near future. Will the infusion of capital into the market through different means such as the economic bailouts cause inflation? Also, as consumer confidence lowers and international confidence in the dollar is lost - the desire to hold something other than dollars would flood the supply and cause inflation of the dollar, right?"

This is a great and timely question, in fact, Bloomberg just today has an article about the surge in gold prices.

First let's address the question of gold as a hedge against inflation. Before I start with this, let me just say that right now, I am more worried about deflation than inflation. While it is true that loose monetary policy (and it is as loose as we can make it at the moment) could ignite inflation, we generally look at wages as the key channel, and with unemployment going berserk I am not expecting wages to be going up any time soon.

Okay, so there is some truth to the idea that gold has some 'intrinsic' value: it is awfully pretty and malleable so works well for jewelery, it is a good conductor and doesn't corrode, so good for electronics, etc. And there is only so much of it in the world and mining adds to the total stock of gold about 2% a year (from one estimate I have read) so it does not, in general, keep up with average growth. That is to say, there is a fundamental demand for it more than just because it is pretty and there is a limited supply which means that there is a sense in which its value is secure. But one must be careful with this logic, for the demand for gold can fluctuate wildly for many reasons, one of them being investors trying to hedge against inflation. Below is the 30 year dollar gold price graph. Notice that during the high inflationary period of the late seventies gold prices skyrocketed, but they collapsed almost as quickly after Volcker put the clamps on the money supply.
So if you got it just right and bought gold in Jan 77 and sold in Jan 80, you did really well, but if you bought in 80 and sold later, you did not. Another thing to keep in mind is that we have learned many lessons from the late seventies loose monetary policies, and should not ever expect a repeat of that again. Monetary policy for the last 25 years is almost always first and foremost used to keep inflation low and predictable. By the way, notice that gold has risen quite a lot in the last few years, partly because of the huge pools of money looking for outlets, partly because of high industrial and consumer demand and partly because of the relatively weak dollar. So buying now (while the price is already high) does not to me seem like a very good bet. As soon as the panic subsides, people will be looking for investment opportunities and pulling out of gold.

The next question is whether the bailout plans could ignite inflation. Well, in theory yes, but the economic situation is so terrible right now, even though we are talking about potentially billions of dollars being spent, it is still unlikely to do much more then staunch the bleeding. There will come a time, however, when the recovery begins, lots of hiring happens along with lots of new investment and this will be the crucial time for the Fed to keep money loose enough to allow this to happen robustly, but not too loose as to cause high inflation (higher than 3%).

The third question is about whether loss of confidence in the US and in the Dollar will lead to Dollar depreciation. Yes, we should see a loss in the Dollar in general when the US economy goes south, interest rates in the US are near zero so there are better returns elsewhere, etc. But, up until just recently we have actually seen an appreciation in the Dollar. This is coming from the fact that, one, the credit crisis is so terrible, people are hoarding their cash and putting it in the safest place on earth: US Treasuries which are Dollar denominated. And two, that this economic downturn is global, so while the US economy is tanking, so are most of the rest of the major economies in the world. So there really isn't a lot of competition for the Dollar right now.

So, I don't recommend investing in gold if you are worried about inflation and trying to protect yourself from a high inflationary episode. If you want to do this, there are extremely effective ways that come straight from the US government: Treasury Inflation-Protected Securities (TIPS). But, in general I would not be worried about inflation at the moment - I would be (as I am) deeply distressed about the potential for a deflationary episode. I believe we need fiscal stimulus big time and right away.