What if the Dollar Collapses?

We get this question with some regularity, so I figured I'd write up our thinking. The dollar has been gaining strength against foreign currencies since last July, when the bottom started falling out of the US economy. By "gaining strength" we mean that a dollar buys more units of a foreign currency than before. If one dollar bought 50 units of currency X, it now buys 60 units. If a cup of coffee in country X cost 50 units in July, and 50 units today, we come out for the better since we now have both the cup of coffee and 10 extra foreign currency units to spend. That's why we use the word "strengthen" -- our currency buys more foreign stuff, all else equal. The word "strengthen" sounds positive, and the word "weaken" sounds negative. As you might expect, people tend to panic at the thought of our dollar weakening or even plummeting. If it sounds bad, and if it uses scary words to describe, it must be bad...yes?

Before we get to worrying about that, I pose the somewhat glib and off-hand question, "Why do you care if the dollar falls?" What really happens when the dollar falls? What direct effect does it have on your life? The answer -- like everything in economics -- is, "It depends." In ECON 101, we learn that when the price of something changes, there are two opposite effects going on at the same time. On the one hand, the seller gets more money per unit sold and that puts upward pressure on his total revenues (the "Income Effect"). On the other hand, people will reduce the number of those things they buy by shifting their purchasing to substitute products (the "Substitution Effect"). That puts downward pressure on the seller's revenues. Which effect wins out? No way to know -- it depends on the specifics of the situation. And so it is with the selling of the dollar (we being the seller).

So again, why should I care if the dollar falls? First, a cup of coffee when I travel overseas will cost more. If you travel a lot, that might matter to you. Generally, there will be upward pressure on the price of foreign-made goods. An LCD TV might cost a little more. A Toyota might or might not -- many are made here in the US of A. In the full picture of our spending habits, these price movements are not all that powerful -- we can substitute our buying among various goods, made in various countries and manage our standard of living accordingly.

There is one import whose price can rise with a falling dollar and harm us more quickly: capital. A major portion of our global balance of payments is the purchase by foreigners of our debt -- we import dollars by exporting debt. If the dollar begins to slide, foreigners might wish to own fewer of our bonds since the value of those bonds will be falling when measured in their own local currency. Selling pressure in the bond markets will drive domestic interest rates upwards.

And finally, there is one import product which we cannot easily live without or substitute away from: Oil and other natural resources. A slide in the dollar can cause our cost per-barrel of oil to rise. If the dollar is buying fewer and fewer units of other currencies and of foreign-produced goods, the oil exporting countries will take that into account and demand additional dollars to make up the gap. It is this effect that most concerns us.

A long-term slide in the dollar on the world exchange markets will most likely lead to persistently high real interest rates (the amount by which rates exceed inflation), and to higher oil prices. This does not necessarily lead directly to inflation. As we saw in 2007, a spike in oil prices can put the brakes on our economy faster than Merrill Lynch can write bonus checks. Inflation plummeted from 5% to zero in six months.

Which asset classes offer protection? Energy and natural resources stocks (we favor a T. Rowe Price mutual fund); and discounted short-to-medium term bonds in the corporate and municipal sectors. Folks ask us about TIPs, or inflation-protected bonds. These don't provide protection against rising real interest rates. If inflation stays tamed, and interest rates rise, TIPs will not perform well at all. The other asset we are staying away from at the moment is US Treasuries. While they are safe if held to maturity, the yields are absurdly low and do not compensate us for the risk of rising rates as the recession bottoms out.

In sum, we care about a falling dollar primarily in terms of the effect on (1) the globally-set price of oil and other natural resources, and (2) domestic interest rates in excess of the rate of inflation. Remember -- rising commodity and oil prices do not necessarily lead to long-term persistent inflation. The Income and Substitution Effects will pull in opposite directions. In the short-term, the Income Effect usually dominates. In the fullness of time, the Substitution Effect will steer our consumption to other energy and resource supplies. As we have written before, you can either worry about short-term inflation or long-term inflation, but you can't have it both ways. We worry more about the long term and will take positions in our portfolios accordingly.