Dollar Depreciation Days

As any Staré Město shopkeeper will attest, the days of the well-lubricated American wallet shedding dollars like a Hilton sister to carry off stockrooms full of Bohemian cut crystal and garnet rings have come and gone.  As Spaniards and Italians stuff their carry-ons, Americans are left scrounging through musty bargain sections, wondering what brute cooked up the myth of the 30 cent beer.  Grumbling over prices, filing through duty free tax forms, during the past year Americans abroad have come to feel the weakening power of the dollar.  While it may seem that American tourists bear the brunt of dollar depreciation, its global effects extend far beyond a decrease in souvenir sales.  The depreciation of the dollar could have serious effects on the economy of the EU and, by extension, that of the Czech Republic.  In order to grasp the possible effects of the depreciation of the dollar in Europe, it´s first necessary to look at the reasons behind the fall.  Unfortunately, that sounds much easier than it is, so, for the sake of simplicity, this column will be split in two parts: this week we will focus on the causes of dollar depreciation and next week we will discuss how we can expect a weak dollar to effect those of us living in Europe.

Unfortunately, there is no clear and easy explanation for the dollar´s recent slide, if only because understanding the movements of financial market is quite beyond the limits of human comprehension. Financial markets, and currency markets in particular, run on intuition and hysteria, not logic; they are notoriously capricious in their movements and so intricately intertwined that the most innocent flap of the wings on one side of the globe will wreak an El Niño-sized havoc on the other.  It is perhaps easiest to understand financial markets not as a clear network of logical connections, but as a giant global game of poker, in which investors, banks, and governments make bets on both the strength of the cards in their hands and the power of their foresight.  The pot, however, not only consists of hard cash, but also political survival, the economic prosperity of entire nations, and, of course, the wellbeing of individual citizens like you.  And, as in the game of poker, the outcome of the game depends less on the cards dealt than the reactions of the players, how well they know each other, their attitudes towards risk, whether they tend to be cautious or foolhardy, and how much money they have to lose. 

The situation leading up to the recent decline in the value of the dollar was caused by a series of bets – some good, mostly bad.  Although for many its effects have only recently hit home, the dollar has been gradually declining since the introduction of the Euro in 2002, when many investors decided to place their money Euro instead of the dollar as the currency most likely to succeed.  After the events on the U.S. financial markets this past August, that decline accelerated, and the fragile state of the dollar was thrust into a harsh and glaring spotlight, sending both American consumers and foreign investors into a panic and resulting in the global credit crunch you have all heard so much about.

If you have been following the markets over the past six months, you are probably aware of the financial turmoil infecting the global financial markets; however, if you have not, it bears examination. In brief, the experts on Wall Street devised a series of complicated investment schemes to help them minimize the risk of putting their money into some very dubious ventures, in the process generating pretty hefty profits.  Some of these dubious ventures included buying up mortgage loans from banks and trading them as they would stocks.  This encouraged banks to take greater risks themselves and to grant mortgages to people with few prospects of paying them back – the infamous subprime loans everyone is talking about.  When the recipients of these mortgages defaulted on their loans, those seemingly infallible financial products crashed, causing a lot of people to lose a lot of money and terrifying banks and foreign investors.

In hindsight, we can say that they all should have known better.  A similar crisis occurred in 1998 that should have taught both investors and financial alchemists that there is no system that can beat both risk and uncertainty; like a good poker player, the smart investor should realize that random chance always trumps the most well thought-out strategy. Unfortunately, the repercussions of Wall Street´s overly optimistic betting are not only pretty serious, but have also become nearly epidemic in scope.  Their most obvious and immediate effect was to frighten both banks and investors into keeping their money close, which reduced the amount of money being lent and spent on the market in the U.S. and abroad, eventually leading to a general hysteria regarding the stability of the U.S. economy.  In an attempt to stave off an impending recession, the Chairman of the United States Federal Bank, Ben Bernanke, reacted to these fears by drastically reducing the interest rate at which banks borrow money to repay their loans.

And here we arrive at one of the major reasons for dollar depreciation.  Bernanke intends these rate cuts to help the U.S. economy, and they well may, but they have also resulted in the drastic depreciation of the dollar on the global market.  This has much to do with image politics: if it seems like the Fed is worried about a possible recession, then it seems like it might be a good idea to pull out of U.S. investments before it hits.  Also, investors have lost faith in Wall Street´s complicated financial technologies and are ready to return to more secure and less innovative ways of investing on non-U.S. markets.  Thus, as investors sell their dollars to buy up other currencies, they increase the amount of U.S. currency on the market and, according to the laws of supply and demand, reduce the value of the dollar.

Does this portend the cataclysmic downfall of the United States and the rise of a new European or East-Asian superpower?  Probably not.  The depreciation of the dollar may actually help the United States right now.  The country appears to be entering a recession, and an undervalued dollar means that people will be spending more money domestically, businesses will export more, and the country will reduce its current deficit – all very positive things for the U.S. economy.  In fact, during the past week, the dollar experienced a sort of rejuvenation as investors start to bet that the U.S. recession will spread and other currencies (like the Euro) will undergo a devaluation as well.

Will the dollar depreciation really have an effect on the European economy?  Undoubtedly.  The question is what exactly the extent or nature of this effect will be.  This, however, is next week´s topic, and hopefully the events of the upcoming week – in particular the market reaction to the G7 meeting last Saturday – will make the answer to this question a little more clear.  However, as we have seen, predicting what the cards have in store is more like gambling than science.  Fortunately, we aren´t the ones that have to make the bets.