The Dollar is Falling! The Dollar is Falling!

I hear this one often enough, especially from my liberal friends. Thomas Friedman goes on about it in today's column:

"When people ask what we are doing about these twin vulnerabilities, they have a hard time coming up with an answer," noted Robert Hormats, the vice chairman of Goldman Sachs International. "There is no energy policy and no real effort to reduce our voracious demand of foreign capital. The U.S. pulled in 80 percent of total world savings last year [largely to finance our consumption]." That's a big reason why some "43 percent of all U.S. Treasury bills, notes and bonds are now held by foreigners," Mr. Hormats said.

And the foreign holders of all those bonds are listening to our debate. They are listening to a country that is refusing to raise taxes, and an administration talking about borrowing an additional $2 trillion so Americans can invest some of their Social Security money in stocks. If that happened, it would almost certainly weaken the dollar, further depreciating the U.S. Treasury bonds held by all those foreigners.

On Monday, the Bank of Korea said it planned to diversify more of its reserves into nondollar assets, after years of holding too many low-yielding and depreciating U.S. government securities. The fear that this could become a trend sparked a major sell-off in U.S. equity markets on Tuesday. To calm the markets, the Koreans said the next day that they had no intention of selling their dollars.

Look, this is pretty simple. The dollar rises and falls with interest rates. When interest rates are low, (especially relative to inflation), the dollar will decline. When interest rates are high, the dollar will rise. This is not all that surprising when you think about it. Foreigners are looking for two things when they invest their money. Safety (and US Treasuries are the safest investments in the world) and return.

Those who disagree usually point to the Euro/Dollar exchange rate. The advantage to this from their standpoint is that the Euro has only been around for a few years (it started trading in late 1998). The dollar has shown a rather precipitous plunge in value against the Euro. Where one Euro used to be worth as little as 84 cents, it is now worth $1.32. Sounds horrifying, but in fact the dollar bounces around against other major currencies as well.

Consider the British pound. It has been around for quite awhile longer than the Euro, with the result that we can watch the ups and downs for several cycles of the economy. Exchange rates for any period in history can be calculated here. The pound is currently worth about $1.91, while as recently as June of 2001, it was worth $1.38. You can see that's a pretty sharp increase in the value of the pound compared to the dollar in just 3-1/2 years. Is the sky falling?

Hardly. Let's go back further in time. In September of 1992, the pound was worth a shade over $2.00. This represented a substantial rise in value for the pound (and loss in value for the dollar), which had been worth as little as $1.05 in March 1985. But in 1980, the pound had been worth as high as $2.44, much higher than today. This had been a substantial loss in value for the dollar, since the pound was worth only $1.64 in late 1976. But before that, the dollar had been worth quite a bit less, with the pound worth over $2.60 in early 1972.

Beginning to see the picture? The dollar rises and falls against the pound, sometimes quite sharply, but always staying within a range. The current fall is not that significant in historical terms, as the dollar was lower in 1992 and much lower in 1980 and the early 1970s.

So don't worry about the chicken littles out there. Thomas Friedman has an impressive grasp of foreign policy, but he has little understanding of basic economics.