Wednesday, January 28, 2009

Future Concern: Run on the Dollar

The current global economic crisis is causing governments around the world to take aggressive measures to mitigate the downside risk. One of the most aggressive is the US government which has basically thrown the kitchen sink at the problem. What didn't we have? Bank bailouts; auto bailouts; reduction of interest rates to 0%; massive stimulus packages and tax rebates; you name it, we got it. AND we're not done yet. The problem is that all the money for the bail-out needs to come from somewhere, and the main sources for spending? Debt and good ol' fashioned money printers. All of this leads me to be concerned about the value of the greenback. 

What is a "run" on a currency? Much like a run on a bank, where investors all try to take their money out while the bank does not have enough liquid assets to satisfy everyone, a run on a currency is a case where investors panic and try to quickly pull their investments out of a particular currency and move to a currency that is perceived as being stronger.

How could a "run" begin? The government is raising incredible amounts of money by selling its debt to individuals, corporations and foreign governments. Essentially, our government is taking a huge mortgage on our future. But here is where it gets scary: what if people start to get scared about lending to the US government? What if folks suddenly realize that we Americans are living well beyond our means and maybe our IOUs are not worth all that much? What if they decide that the US is too risky of an investment and that all this money that's being pumped into the economy and printed up by the Fed is going to cause inflation and erode the value of their investments? If that happens, they might decide to get the hell out of the market, while their investment is still valuable. If enough investors attempt this at once and head for the exits simultaneously, all trying to sell their dollar denominated investments in favor of other currencies, we could see a sharp drop in the value of the Dollar.

What would a run on the Dollar mean for you? A dramatic weakening of the Dollar could have some alarming consequences. For one, the government would feel obliged to try to defend the currency. It may be able to do so by offering significantly higher interest rates which will encourage folks to stay in the market. Unfortunately, higher interest rates tend have a weakening effect on the economy, since consumers and businesses find it harder to borrow money at higher costs and therefore need to scale back consumption and investment. At the same time, a weakening of the dollar would make imported goods more expensive in the US. For example, if the Dollar falls compared to the Euro, and European exporters do not reduce their price in Euros, American buyers will need to pay more in Dollars to meet the same price. Our purchasing power abroad, and therefore our standard of living, will decline. 

More ominously, one of the key things about the US currency is that many governments around the globe use the Dollar as a reserve currency - i.e. they save their spare cash in Dollar denominated investments or simply hold large amounts of US currency. If the Dollar weakens, it is very possible that some countries will decide that this is no longer a good solution and that it may be better to diversify into other currencies. This would have implications that go well beyond the scope of this post, but they are not good.

The good side of a weak Dollar. As the Dollar gets weaker, American goods and services become more competitive in the international markets. This can lead to an export led recovery, and reinvigorate such sectors as manufacturing, which have been steadily losing jobs to foreign competition. So, it's not all bad, but let's try to not go there anyway...

Is this a likely scenario? God knows. I don't. However, there is increasing chatter from economists who expect that the Dollar will weaken significantly once the global economy stabilizes, unless the US government is aggressive about soaking up any superfluous liquidity and vigilantly combats inflation and deficit spending.

How you can protect yourself from a worst case scenario. Well, a relatively easy solution is to diversify your portfolio into foreign denominated investments. For example, E*Trade offers investors the opportunity to open up brokerage accounts in one of several foreign subsidiaries and these accounts are denominated in the local currency. If you are not into opening up such an account, a simpler solution may be to invest a significant chunk of your portfolio in foreign stocks, or the stocks of American companies that get much of their revenue internationally. This is our preferred solution: we try to maintain 25% to 30% of our portfolio in international funds.

I sure hope such a scenario will not come to pass, but with the dramatic global economic turmoil, nothing seems impossible these days. 

Enjoyed this post? Please consider subscribing to Money and Such by free RSS Feed or by email.

1 comment:

plonkee said...

I suspect that a run on the £ is far more likely than one on the US$.

Oh well, we'll likely switch to the € anyway at some point.