US DOLLAR 101
The Well-Timed Strategy for Week Ending October 19, 2007
by Peter Navarro, Ph.D.
October 15, 2007

NOTE: This week, the newsletter will be limited to a bit of a more lengthy discourse on the declining dollar and its effects on our financial markets and broader economy.  

Navarro's Big Economic Picture
The Dollar Must Not Be Weak For America To Be Strong 

The US dollar index, which measures the greenback's strength against other major currencies, recently hit its weakest level since 1973.  However, many experts believe the buck hasn’t even hit rock bottom -- and project a further major decline based on chronic US trade imbalances. To understand the three major forces driving this chronic trade deficit is to understand what must be done to restore confidence in America's currency.

First, America's chronic trade deficit may be directly traced to its lack of fiscal responsibility and monetary restraint.  The US has run chronic budget deficits throughout the Bush administration which have over-stimulated consumer demand for foreign imports.  A primary culprit here is the volatile combination of simultaneously cutting taxes and fighting a very expensive war.  At the same time, the US Federal Reserve has engaged in an ultra-easy monetary policy since the 9/11 terrorist attacks.  This has likewise over-stimulated demand for foreign imports -- principally, by turning the American home into an ATM.

Second, even as US oil consumption has only barely inched up, our oil import bill has skyrocketed.  The culprit here is persistently high oil prices.  Now, as OPEC's kings and princes sit uneasily on a growing mountain of dollars, some are beginning to quietly dump dollars in foreign currency markets, creating, in effect, a speculative OPEC dollar downdraft.

Third, there is the burgeoning US-China trade imbalance -- more than $250 billion a year and counting.  While cheap labor provides China with an important edge in world's export markets, much of China's competitive advantage may be traced to a set of unfair trading practices that range from illegal export subsidies and rampant counterfeiting and piracy to lax environmental and health and safety regulations.  However, the most distorting of China's unfair trading practices is its flagrant currency manipulation.

China manipulates its currency by pegging its value to the US dollar.  It maintains this peg by recycling the dollars US consumers spend on cheap Chinese goods back into the US bond market. China's currency manipulation, in turn, forces other countries like Japan, Malaysia, Singapore, South Korea, and Taiwan to manipulate their own currencies for fear of losing market share to an emergent China.  

It is precisely this US dollar-Chinese yuan peg and its collateral effects on other Asian currencies that is forcing the Euro to bear the brunt of the dollar's decline.  Even as the European economy continues to downshift, the Euro keeps ratcheting upward.  The resultant reduction in European export competitiveness virtually guarantees slow growth -- and a possible recession -- in Europe.

Now that we understand why the dollar is in its freefall, it is useful to ask whether a falling dollar is good or bad for America?  The falling dollar is good because US industries sell more of their exports and US consumers buy fewer foreign imports.  This means more jobs for America and a reduction in the US trade deficit -- just as a flexible currency is supposed to do.

The falling dollar is bad, however, because US consumers must pay more for foreign imports.  This makes a falling dollar inflationary.  This inflation, in turn, helps drive up interest rates and mortgage rates.  By reducing consumption and causing inflation and higher interest rates, a weak dollar can, in turn, induce a recession.

As for the worst-case scenario, a falling dollar has the real potential to trigger a stock market collapse.  If enough investors believe that the dollar is indeed going to drop by another 15% to 20% or more and suddenly cash out of the US stock market to invest elsewhere, a crash -- followed by a severe recession -- becomes a foregone conclusion.

To dodge this declining dollar bullet, it is critical that the US government began to practice both fiscal and monetary discipline.  This means balancing our budget and engaging in a neutral, rather than an easy money policy.

It is equally critical that the US crack down on China's unfair trading practices.  This is particularly true of China's currency manipulation which is grossly distorting currency values around the world and particularly punishing the euro.  

The bottom line is that for America to be strong, its currency cannot be weak.

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
Email  |  Website

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.