Implications of a Doomed Dollar

My friend Jeff Hummel has been arguing for some time that the U.S. is eventually going to default on its debt. Central to his argument is the fact that an increase in the perceived risk of default increases the risk premium the U.S. has to pay to lenders. Since the debt is large (and rapidly getting larger) an increase in the interest rate the U.S. has to pay results in significantly increased budgetary problems, which results in an increased risk of default, which results in a further increase in the risk premium—a positive feedback mechanism. I do not know if his prediction is correct, nor do I know whether, if it is, default would be via repudiation or inflation, but it is at least an interesting argument.

I was reminded of it recently when I received an Email from The Motley Fools, investment advisers who for some reason have me on their mailing list. The title is "Read This Because the Dollar is Doomed." The authors argue that the U.S. trade deficit, the U.S. budget deficit, and the willingness of the U.S. to pay for things by printing money all threaten the dollar. They conclude that "This should be worrisome news if you earn a dollar-based salary, keep a dollar-based bank account, or invest in dollar-denominated U.S. stocks and bonds. Why? Because as the dollar declines in value, so too will all of your earnings, savings, and investments. And that's scary stuff." They argue that the solution is to invest in "stocks that do business in other currencies ... and specifically in currencies that you suspect will rise against the dollar over time."

It is possible that the dollar is doomed, but their explanation and advice confuse two different issues—price levels and exchange rates. Inflation due to too much money creation is a problem if you have assets whose value is fixed in dollars, such as T-bills. But it isn't a problem for assets whose value is merely measured in dollars, such as U.S. stocks. If all prices double, the price of Apple computers doubles too, as does the value of Apple stock. Some companies will do better in an inflation than others, in part because some companies have assets or liabilities whose dollar value is fixed. But that has nothing to do with whether the company's stock is dollar denominated.

Nor does it have anything to do with whether the company does business in other currencies. If the value of the dollar drops and the value of the Euro doesn't, then the dollar value of a company that does business in Euros will go up. But so will the dollar value of a company that does business in dollars. The Euros the company is earning exchange for more dollars than they used to, but those dollars are worth less.

There is, however, a different sense in which the dollar might be doomed, with different implications for investors.

Suppose the U.S. price level stays the same but the exchange rate between dollars and other currencies falls. A dollar will still buy the same goods and services in the U.S. as before, but not as many Euros or Yen or Rupees.

Why might that happen? The market exchange rate between the Euro and the dollar is the price at which the number of dollars that people want to sell for Euros equals the number that other people want to buy. One reason to trade Euros for dollars is in order to buy goods in the U.S. and ship them back to Europe, and similarly in the other direction. If that is all that is happening the exchange rate ought to reflect the purchasing power of the currencies, with some complications due to the fact that not all goods and services play a role in international trade.

Another reason a European might want dollars, however, is in order to buy T-bills—more generally, in order to buy U.S. capital assets. If the U.S. is running a large budget deficit, as it is, and if much of that money is being borrowed from foreigners, as it is, then a lot of dollars are being bought in order to lend them to the U.S. government. That additional demand bids up the price of the dollar in exchange markets. The capital inflow appears in the statistics as a trade deficit, since some of the foreign goods the U.S. is importing are being exchanged for capital assets which remain in the U.S. rather than for export goods that don't.

Suppose foreigners decide that lending money to the U.S. government is no longer prudent. That part of the demand for dollars vanishes. The price of the dollar measured in Euros or Rupees falls. Some of the foreigners who have lent money to the U.S. decide it was a mistake, cash in their T-Bills for dollars, and trade those dollars for Euros or Rupees. That increases the supply of dollars on the foreign exchange market, driving the dollar down even farther. The Motley Fool isn't entirely clear about which sort of decline of the dollar he is talking about but one could, with a little effort, take his references to the trade deficit and the budget deficit as suggesting some mechanism along these lines.

What are the implications if the dollar maintains its value domestically but falls in its exchange rate? Americans who hold assets with fixed dollar values are unaffected, except to the extent that they want foreign currency, perhaps for a Paris vacation. Americans who hold stock in foreign companies, or in U.S. companies whose income is largely in foreign currencies, benefit, since their stock is now worth more dollars. The losers this time are foreigners who made the mistake of holding U.S. assets.

It is, perhaps, unreasonable to expect investment advisers to not only understand economics but to explain it correctly to their customers. On the other hand, since which part of their advice one ought to follow depends on what sort of doom the dollar is facing, it would be nice if they at least tried.