It's common knowledge that the value of the dollar is low. But why? And might it plunge any lower? Or is it poised to rally? U.S. News asked Robert Hodrick, a finance professor at Columbia University in New York, to explain what determines the dollar's value and how it affects global investors.
How low is the dollar right now, in historical terms?
The dollar was historically high in 1984, then it weakened in the late '80s and early '90s, then strengthened again. It peaked around 2002 and has been declining since then. Right now it's pretty low, about where it was in the late '80s and early '90s.
And the Bush administration has not really intervened to prop up the dollar, correct?
The Fed clearly watches the value of the dollar and considers that in setting interest rates, but the United States generally doesn't intervene directly in currency markets to try to change the dollar's value.
What risks come with a weaker dollar?
Foreigners could decide that they're tired of financing our current account deficit by investing in the United States, in which case they'd demand a lower price for our bonds and a higher yield to invest in dollars. That would weaken the dollar. The Asian central banks could decide they were holding too many U.S. government securities...and decide to diversify.
But China's central bank, or any foreign investor, doesn't think like that, right?
Right, because they'd be shooting themselves in the foot. They have other goals that are much more important, [such as] employment gains and continued growth in their economy. They need us to fulfill those goals.
There are some good things about a weak dollar, too.
There are. It's good for U.S. workers, because it shifts demand to cheaper U.S. goods. For all the stress Ford and General Motors are under, it would be worse if the dollar were stronger. Basically, any U.S. company that competes with foreigners benefits from a weaker dollar.
What role does the trade deficit play?
If we're buying more goods overseas than we're selling to foreigners, we're demanding foreign currencies more than foreigners are demanding dollars. That drives up the price of foreign currencies if you're buying them in dollars.
That's what's happening?
Yes, the U.S. current account deficit is about $800 billion a year, which means every business day we buy in excess of $3 billion of foreign goods and services more than foreigners buy here.
Which also means that every day, foreigners invest $3 billion in the U.S. economy.
Right. And our asset prices, interest rates, exchange rates, and stock prices adjust continuously to make this happen.... You can't run a large current account deficit forever.
Because eventually foreigners will own your entire economy. Before that happens, you stop buying as many foreign goods, because they start to get expensive, and you start selling them more of your goods.
What's an example of that?
Caterpillar tractors. With construction booming around the world, demand is high for earth-moving equipment. You can either buy it from Japan or the United States, and a lot of people are buying Caterpillar equipment that's made in the United States.
How big a role do speculators play in currency exchange?
A big role. Currency traders and speculators are the same people. If you're a currency trader and you think one currency is likely to weaken, you'll sell that currency as quickly as possible. That lowers the price, or the value of that currency.
So when consumers hear of "speculators," that sounds like something that could be destabilizing. Is it?
I don't think currency speculators are a force for instability. They create liquidity. They create the whole market for currencies, really.
Where do threats of instability come from?
There are several major factors. Inflation is a big one. Another factor is the growth rate of the economy, and as you know there are concerns that the U.S. economy could slip into recession, induced by declines in the housing market. Growth in Europe and Japan, and more so in China and India, leads to generally higher rates of return for people who invest in those countries.
What are some other factors that can cause instability in exchange rates?
Threats of war are an obvious one. If there were another major terrorist attack in London, it would probably lead to a stronger dollar. Oil is another one. Oil is priced in dollars. Then the question is: How do the producers of oil invest the dollars they are saving? If they're investing in dollars, then that's good for the dollar. If not, it could weaken the dollar.
How could the dollar get stronger?
Well, the trade deficit is weighing on the dollar, and if the United States can grow its way out of the problem, that would be great.
Will you make a guess about which way the dollar will go over the next year?
I'd prepare for the full range of possibilities. Investor psychology is all over the map.