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The Incredible Shrinking Dollar

I've been watching with some amazement as the price of a barrel of crude continues to march steadily upwards towards the $100 mark. Some in the media has tried to explain this move as being the result of two ongoing geopolitical flashpoints: the threat of a Turkish invasion of northern Iraq and a possible strike on Iran by the US.

This has never made any sense to me because I strongly discount the possibility of either of these happening in the next few months. Turkey will continue to bluster about invading northern Iraq and they may conduct some very short-lived forays and bombing missions, but they're not stupid enough to try and actually occupy parts of Iraq (only George Bush is that dumb). They will also likely steer well clear of any of the country's oil infrastructure so as to not bring down the wrath of the western world upon them.

And while the Bush administration continues to lay the groundwork for a possible strike on Iran it doesn't appear that the timing is quite right for that given some recent indicators of a possible warming of relations. We know Dick Cheney is pushing hard for a strike on Iran but it doesn't appear as if he's calling the shots anymore (or so we hope).

So what then, explains the rapid rise in the price of oil? An article appearing in the Christian Science Monitor provides a possible explanation:

"What's happening to the dollar and gold and oil is that there is an expectation ... that the Federal Reserve is going to inflate and devalue [the dollar] in order to offset the turbulence that's going on in residential real estate and mortgage finance," says Michael Darda, an economist at MKM Partners, an investment firm in Greenwich, Conn.

By his estimates, $30 to $40 of the current per-barrel price of oil should be understood as an adjustment to account for the falling dollar.

Mr. Darda views the US economy as strong enough to weather the housing downturn without falling into a recession. Thus, he says, the Fed's recent interest-rate cuts are a bad move that will come back to hurt America. When the Fed later has to raise rates to curb inflation, he says, that "could cause a recession."

Now this explanation makes some sense to me. If people expect that the US central bankers are going to pursue an expansionary monetary policy to help rescue the mortgage and investment bankers who have made extraordinarily poor decisions over the last few years, then it's highly probable that the dollar will continue to fall. The laws of supply and demand dictate that the price of a good falls as more of that good becomes available in the marketplace given a steady demand. In this case, the good we are talking about is dollars, and as the central bankers flood the system with more dollars that should cause a corresponding decrease in the value of all dollars. This is one of the primary reasons we have seen the dollar fall so dramatically against almost all the world's currencies as of late.

Consequently, if people perceive the dollar to be decreasing in value they are going to demand more of them in exchange for literally everything you can buy with a dollar. We see this most dramatically with the price of commodities like oil and gold, but we also see it with the price of other currencies. For example, it now takes you almost a $1.08 US to buy a Canadian dollar (not long ago it was around $0.70), and it takes $1.46 to purchase a Euro. This is bad news for people who have a lot of dollars in the bank, particularly the Chinese:

A Chinese central banker said the dollar was losing its status as the major global currency and a top lawmaker said China should balance the make-up of its $1.43 trillion foreign reserves stockpile to take advantage of appreciating currencies.

A rapid move by the Chinese to divest themselves of some of their gargantuan horde of dollar-denominated assets could cause the orderly decline in the value of the dollar that we have seen turn into a wholesale rout. Most analysts discount whether the Chinese would do this because it would have a potentially devastating impact on their number one export market and would further dilute the value of their dollar holdings.

Still, there is still a substantial risk that a run on the dollar could develop over the coming months. In this scenario, Ben Bernanke and the Federal Reserve would be forced into a restrictive monetary policy that would push up interest rates in order to defend the dollar's value. In an economy that appears to be losing steam that could be a recipe for disaster: a falling dollar, inflating prices, slowing growth and rising interest rates all at the same time.

Ultimately, Ben Bernanake's decision to pump up the markets a few months ago when the subprime market collapsed may turn out to be a very bad move that helped to precipitate the fall of the dollar and the nearly $100 oil prices that we now see. No doubt, Bernanke is right now huddling with his team figuring out what to do about yesterday's 350+ point drop in the Dow. God forbid that we should actually see the stock market go down more than 5%. Fire up the printing presses! We wouldn't want anyone to actually lose any money in the stock market now would we?

Note: Wizbang Blue is now closed and our authors have moved on. Paul Hooson can now be found at Wizbang Pop!. Please come see him there!

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Comments (1)

Steve Crickmore[TypeKey Profile Page]:

In January 2002, (before Bush started the invasion of Iraq and his heavy borrowing to pay for it) the Canadian dollar was worth 62 cents US, now it's worth $1.10. Pretty soon the US will have an isolationist policy by necessity. It will be too expensive to visit or invest anywhere else.


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