Worth Even Less: A long-anticipated decline in the dollar is underway and it won't stop soon. Douglas O. Walker Professor of Economics Robertson School of Government Regent University Virginia-Pilot—January 7, 2007

    The long-awaited major realignment of the U.S. dollar against all world currencies has finally begun, and its effects will markedly shape the outlook for world economic growth in 2007 and beyond.

    Over the five years since early 2002, the dollar has slowly declined and has now lost 25 percent of its value in terms of the euro, the pound sterling, and the Canadian dollar. In 2007, the fall will widen in terms of currencies appreciating in value and deepen sharply in its magnitude. These changes in exchange rates will profoundly affect the economic prospects of all countries.

    This is the third major decline in the dollar in the postwar period. The first took place in the 1970s when U.S. inflation weakened the Bretton Woods fixed exchange rate system and an oil embargo and upsurge in oil prices caused a recession and precipitous drop in U.S. terms of trade.

    Although the economy eventually adjusted by expanding export volumes greatly, the increase in exports was at first insufficient to offset the loss of international purchasing power caused by much higher oil prices. Consequently, the dollar fell markedly in value in the 1970s as part of an adjustment to a markedly changed international economy.

    The second decline occurred in the mid-1980s, following measures taken by the Fed to counter the runaway inflation that had built up in the ’70s. As the pace of domestic economic activity weakened in the early ’80s, inflation subsided, import demand contracted, oil prices fell and a very strong dollar emerged as foreign capital was attracted to high U.S. interest rates.

    Still, the combination of a strong dollar and a strong revival in growth soon led to rapid increases in import volumes and a much slower increase in exports. As the imbalance between exports and imports widened, the dollar headed down in a steep fall in 1985. This fall in the dollar can be seen as a response to persistent trade deficits that had widened despite a revival in growth in its major trading partners.

    In both cases, declines in the international value of the dollar brought about a significant improvement in the U.S. balance of payments. The adjustment process was demanding, however, and associated with wide swings in the pace of growth in the domestic economy and a slower expansion in world economic activity as the world’s largest economy brought its trade deficit under control mainly through a slowdown in its rate of import absorption.

    Following each period of adjustment, the dollar once again rose on foreign exchange markets, discouraging exports, encouraging imports. The strengthening of the dollar from 1995 to 2001 follows this pattern as the U.S. economy was robust: high U.S. interest rates attracted foreign capital and foreigners sought safety from global turmoil in U.S. markets. The higher dollar, however, also brought another extended period of rising trade deficits as U.S. export volumes lagged and external receipts at times shrank while import volumes rose at double-digit rates.

    The dollar began its latest decline in early 2002 when the deficit reached 4 percent of the gross domestic product and U.S. net external liabilities were rising rapidly. The deficits of the early years of the decade could be explained as a temporary falloff in external receipts due to faltering U.S. exports in a weakening world economy. However, as the world economy recovered, U.S. exports nevertheless continued to lag U.S. imports, a trend aggravated by declining terms of trade as oil prices began to rise.

    Extraordinary and unsustainable inflows of foreign capital financed the growing balance of payments deficits of these years. These inflows not only bridged the gap between U.S. domestic investment and its saving, thereby maintaining the expansion of the economy, but they limited the decline in the U.S. currency. Given these inflows, and despite the slow downward drift in the value of the dollar since 2002, by the end of 2006 the trade deficit had ballooned to unprecedented levels.

    In 2007, a combination of factors will place extraordinary pressures on the dollar.

    In the first instance, the huge accumulation of U.S. dollars stemming from past U.S. deficits and the possibility of its depreciation may well cause private foreign investors to change their preference for dollar-denominated U.S. stocks, government securities and corporate bonds. This will make the deficit that much more difficult to finance.

    Similarly, there is talk – perhaps more than talk – of foreign governments reducing their exposure to the dollar. Recent data from the Bank for International Settlements, for example, seem to point to some countries shifting oil income into euros, yen and sterling. Central banks with large dollar holdings could also switch their reserves out of the dollar and into gold, sterling and euros. Any move by private investors or governments to reduce their demand for dollars could lead to a sharp drop in the value of the dollar.

    If international monetary stability is to be maintained, a substantial realignment and depreciation of the U.S. dollar against all world currencies must take place in 2007. The extent of the dollar’s decline will be large and, because it will be differential across many currencies, will cause a major change in the pattern of world production and trade.

About the Author:
Dr. Walker  is a professor of economics in the Robertson School of Government at Regent University in Virginia Beach and serves on the board of directors of the World Affairs Council of Greater Hampton Roads.