The Economic Situation in the US Seems to be Getting Worse

The recent drop in the value of the U.S. dollar might be viewed by some U.S. exporters as a sign that they might finally be able to improve their competitiveness in the international markets, but for the rest of the world it is a quite worrying sign.

The situation would not have been so bad had the U.S. consumers not been so willing to buy imported goods. Had the trade deficit been a bit more under control, the drop in the price of the dollar might have meant increase in competitiveness and even perhaps a better economic future in the near-term. However, since the U.S. continues to import significantly more than it exports, despite the recent falls in the U.S., all that the fall in the currency does is to import inflation.

The risk to the dollar now seems even more worrying since the popularly held belief that the Chinese and Japanese governments would not sell their dollars because that could cause a further drop in the value of the currency and further exacerbate their losses might not hold for much longer. The Chinese and Japanese holders of dollars are now reaching the point that most investors who start considering cutting their losses get to. Scientific studies have found that investors are much quicker in cashing in their gains than they are in getting out of loss making situations. They are much slower to accept that they have lost money and despite ample evidence that they might lose even more hold off selling in the hope of a reversion. The kinds of comments that are coming out of the finance ministries of China and Japan point to this fact, that they are also slowly reaching that point. They realize that a change in their global currency reserve allocations might cause a huge loss on their current dollar holdings, but they also know that holding on might be more costly.

The result might be a very severe fall in the dollar.

If that does in deed take place, the slowing U.S. economy might start entering a recession. The reason is that the U.S. will likely be hit with a double whammy if the two Asian giants reduce their holdings of the dollar, which has so far kept U.S. interest rates low. If they switch to other currencies, cost of borrowing will certainly rise in the U.S., making the practice of spending the money made on rising house prices and falling rates less viable. That could, of course, cause the trade deficit to fall. However, it all depends on how fast that change takes place. If the U.S. consumers continue to demand foreign goods, while at the same time seeing the value of the dollar fall and the economy slowing down, the likelihood might be stagflation; rising prices during a recession.

Of course, investments in technology and advanced production facilities should help the U.S. bounce back and become a major net exporter once again, but the period between the current falls in the value of the dollar (possibly further exacerbated by the sale of dollar reserves by China and Japan) and rising interest rates, which could cause the economy to enter a recession, is what determines the degree of pain that has to be endured.

If the current policy of the Fed chairman is what is to be believed, his decision to raise rates to control inflationary pressures might further exacerbate the situation. Of course, if he does not increase rates, and as some suggest reduce it, inflation might start to get out of hand. But, the question is does it matter with Dr. Bernanke does at this stage? If the cost of borrowing rises in the market due to the reserves being switched out of the dollar, the FED chairman might find that whatever he decides to do with interest rates might be ineffective.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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