Tuesday :: Feb 22, 2005

The Falling Dollar, Inflation, and Oil

by CA Pol Junkie
Click on chart to enlarge

The above graph shows that the dollar has resumed its plunge versus the Euro today, as investors watch the central banks to see which ones blink first. Yesterday, it was South Korea's central bank, the world's fourth largest, which indicated that it would diversify its holdings away from dollars. The basic problem is that the United States is exporting dollars in large quantities. We exported $617.7 billion in 2004 ($162 billion to China alone) to balance the difference between how much we bought in imports versus how much we sold in exports. We also ran a federal budget deficit of $412 billion, much of which was financed by foreign central banks purchasing United States treasury bonds.

The world is thus awash in dollars, and excess supply means falling value. Economics dictates a gravity toward balancing a trade imbalance by reducing the value of the currency of the country in deficit (the U.S.), making U.S. exports cheaper and foreign imports more expensive. A drop in currency value has the benefit in that it supports the manufacturing sector, which is why China and Japan in particular have been buying dollars to support their own manufacturers.

So what's the problem? As imports get more expensive, imported goods cost more, which means inflation. Our dollars won't buy as much as they used to, so we all feel poorer. Interest rates rise as the Federal Reserve combats inflation. People with adjustable rate mortgages pay more and feel poorer. The housing market (including home construction) slows as fewer people can afford a new mortgage. Between inflation and high interest rates, that means less buying power, which means less consumption and a weaker economy.

Oil is a special case. Ordinarily, consumption of a product decreases as price increases. Imported oil cost $22 per barrel in 2001, but an average of $36 per barrel in 2004. Yet, United States consumption increased from 19.6 million to 20.4 million barrels per day over the same period. We are dependent upon oil, and consumption will only decrease as a long-term response to high prices as people gradually trade in their Ford Expeditions for Ford Escape hybrids.

We've found ourselves in a vicious circle:

- The value of the dollar falls, which means oil exporters increase the price in dollars so they still get the same value. We keep buying the oil regardless and send even more dollars overseas, which increases the trade imbalance and drives the value of the dollar down further. Lather, rise, repeat.

- As the dollar drops, foreign central banks don't want to be the last ones holding dollars (like South Korea), so they reduce their dollar holdings. Demand for the dollar drops, so the dollar falls, putting more pressure on foreign central banks to dump their losing investment in America. Lather, rise, repeat.

- As the dollar drops, inflation and interest rates increase, reducing Americans' buying power and consumption, stalling the American economy. A weaker economy increases the federal budget deficit, increasing the need for foreign buyers of U.S. treasury bonds, which raises interest rates and decreases the value of the dollar. Lather, rinse, repeat.

Thanks to the stunningly short-sighted fiscal and energy policies of George W. Bush and the Republican Party, America is screwed. The tax cuts of George W. Bush are making America poorer, and will continue to do so until the policies are reversed. Escalating energy prices will become a yoke around our economy's neck, until we reduce our demand for oil. The only question is how far down the path we will go before turning back.

CA Pol Junkie :: 12:33 PM :: Comments (39) :: Digg It!