News > Wilfred Vos´ Corner > What Will Happen to the U.S. Dollar? Should We Care?
What Will Happen to the U.S. Dollar?
Should We Care?
March 15, 2010

A History of Self-Inflicted Wounds
On August 15, 1971, facing mounting inflation and the escalating cost of the Vietnam War, Richard Nixon took the U.S. off the gold standard, which had been in place since 1944. The gold standard required that the Federal Reserve back all dollars in circulation with gold. Now, the government could "print" money in infinite quantities (which does not hold value) and not worry about backing it with a finite amount of gold.

With the single stroke of a pen, President Nixon implemented a made-in-America double-digit devaluation of the
U.S. dollar. And the dollar dropped big time, shocking the country's foreign creditors, who watched their investment decline by a large margin.

Is History Repeating Itself?

The U.S. Dollar Today
Today, the U.S. dollar still dominates world trade. At the height of the financial crisis in 2008, investors fled to the
U.S. dollar as a temporary safe haven, causing its value to appreciate by a large margin relative to other currencies or risky assets.

However, the U.S. dollar had been falling steadily since 2002. And, as the world economy recovered last year,
U.S. dollar-selling or depreciation resumed. Countries such as China and Russia have publicly stated that they no longer want the U.S. dollar to be the only reserve currency of the world. In fact, if China sold its U.S. dollar assets, it could cause a significant drop in the value of the U.S. dollar by itself.

As the U.S. incurs their staggering budget deficits, and as economic activity shifts to fast-growing countries such as China and Brazil, the U.S. faces the risk of another devaluation of the dollar. Some argue the U.S. dollar's recent rally against the euro and yen (up almost 10 percent and six percent respectively since December) is less a vote of confidence than a realization that it's simply the best of a bad bunch. The Canadian dollar has faired significantly better.

Now, in defense, the euro currency has been battered by doubts about whether Greece and other fragile Euro-zone countries can manage the spending cuts needed to rein in outsized budget deficits. The worries have weakened confidence in the whole concept of European monetary union.

In the short term, investors are trying to avoid the euro and, in turn, feel that they have no alternative but to buy the
U.S. dollar. However, over the next decade and beyond, the U.S. dollar has nowhere to go but down. In short, foreign investors will punish "reckless U.S. fiscal and monetary policies" and start looking for alternative currencies to invest in.

Can the Depreciating Dollar Shrink Debt?
The U.S. government may in fact be counting on a gradual dollar devaluation to shrink its monster debt and fuel an export boom to propel the economy. A weaker U.S. dollar could be the only solution to many of their problems. (This could be considered my conspiracy theory!)

This contradicts the official line from Treasury Secretary Timothy Geithner, who promotes a strong dollar – but there is a difference between saying and doing. What is clear is that U.S. debt-holders are not interested in losing money. Some of the biggest holders of U.S. dollar assets are also among the fastest growing countries and they do not mind criticizing U.S. policies, particularly now that the financial crisis has eroded the U.S.'s influence and reputation for sound economic management.

China alone holds $2.3 trillion in foreign exchange reserves, with nearly $800 billion in U.S. treasury debt. Premier Wen Jiabao stated, "We have lent a massive amount of capital to the U.S. and of course we are concerned about security of our assets. To speak truthfully, I do indeed have worries."

U.S. is on Borrowed Time to Overcome Challenges
Time is not on the U.S. dollar's side. Emerging markets already account for roughly half of global output, and that share is rapidly increasing. In 2003, Goldman Sachs said the size of China's economy would surpass that of the
U.S. by 2041. Today, it revised the forecast to 2027. China is expected to surpass Japan as the world's second-largest economy this year.

All of which would be fine were it not for the fact that the U.S. continues to live beyond its means. The recent spike in borrowing and spending following the financial crisis is creating a debt burden that, according to Moody's Investors Service, is trending "clearly, continuously upward."

Since the U.S. dollar is in high demand, U.S. borrowing costs remain low. That makes it easier for the government to fund domestic priorities and the average taxpayer to buy a home or start a business.

Provided the U.S. invests in education and infrastructure, maintains high output and productivity, and keeps people employed, they can overcome the challenges. However, the U.S. cannot keep borrowing at its current pace forever, since investors will not lend unlimited amounts of money at near-zero interest rates. When investors stop lending, the U.S. will have to deal with higher interest rates, higher taxes and slower growth, all of which will further undermine its economic dominance.

How Does Canada Compare?
By key measures, Canada is performing better than the U.S. and other advanced countries. Leading authorities praise the stability of our mortgage industry. They point to our financial system as the soundest in the world. Before the recession, Canada had the lowest debt-to-Gross Domestic Product (GDP) ratio in the G7, by far. After the recession, Canada will still have the lowest debt-to-GDP ratio in the G7, and by an even wider margin. In 2010, the International Monetary Fund (IMF) estimates that Canada's debt-to-GDP ratio will be approximately 31 percent; in the U.S., the ratio will be almost 67 percent. (In the U.K. it will be 75 percent; in Japan, 115 percent.) Their ratios will continue to climb, while Canada's will begin falling in 2011. In short, Canada is a good alternative for a reserve currency – which is only going to drive the Canadian dollar higher as investors sell U.S. dollars in order to buy Canadian.

The loonie will fly above the almighty greenback once more – and sooner than many people may think!