Smith Faculty Opinion Article

March 5, 2008

By Dr. Peter Morici, Professor of International Business
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 Peter Morici

Why the dollar is so cheap, and euro and gold are so dear

The dollar is trading at all time lows against the euro and gold for good reasons. The Bush Administration has flooded the world with greenbacks, and global investors have little confidence in the management of the U.S. economy.

During the Bush years, the U.S. trade deficit has doubled. Thanks to dysfunctional energy policies and tolerance for Chinese mercantilism, the deficit has exceeded $700 billion each of the last three years and is more than 5 percent of GDP.

The Bush energy policy emphasizes incentives for domestic oil production and letting rising prices instigate conservation but those have failed. Domestic crude oil production is falling, the price of gas has risen from $1.51 to $3.21, automakers have populated U.S. roads with fuel guzzling SUVs, and petroleum now accounts for about $380 billion of the trade deficit.

Cheap imports from China have chased millions of Americans from manufacturing jobs, as the U.S. purchases from the Middle Kingdom exceed sales there by nearly five to one. The trade deficit with China is about $250 billion.

China has engineered this competitive triumph by keeping its yuan even cheaper than the dollar, euro and gold. Annually, it sells at deep discount about $460 billion worth yuan for dollars, euros and other currencies in foreign exchange markets. That provides a 33 percent subsidy on Chinese exports and keeps Chinese goods cheap on the shelves at Wal-Mart.

The Bush Administration has sought changes in China’s currency policies through diplomacy and has failed. Paradoxically, Treasury Secretary Henry Paulson has managed to tar as protectionist any proposal for U.S. government action to offset Chinese subsidies.

The remainder of the trade deficit is largely autos and parts from Japan and Korea, who through various means have kept the yen and won cheap too.

The huge trade deficit must be financed either by attracting foreign investment in new productive assets in the United States or by printing IOUs. Investment has only provided about 10 percent of necessary cash, so each year the United States sells currency, bank deposits, Treasury securities, bonds, and the like to foreigners. Those claims on the U.S. economy now total about $6.5 trillion.

That floods world financial markets with U.S. dollars and paper assets that function much like U.S. dollars—what economists call liquidity. And, it evokes an iron law of the universe. If you print too much money, it won’t have any value.

Until recently, most of that borrowed purchasing power was put into the hands of U.S. consumers by the large Wall Street banks. Essentially, through mortgage brokers and regional banks, those Wall Street banks loaned Americans money to buy homes and refinance their mortgages. In turn, the banks got the cash needed by bundling mortgages, as well as auto loans and credit card debt, into collateralized-debt-obligations—bonds backed by consumer promises to pay—for sale to fixed income investors, hedge funds and others.

The bankers could get reasonably rich on this scheme but got greedy. Last summer, we learned that the banks were not creating legitimate bonds. Instead they sliced, diced and pureed loans into incomprehensibly arcane securities, and then sold, bought, resold, and insured those contraptions to generated fat fees, big profits and generous bonuses for bank executives.

Now investors ranging from U.S. insurance companies to the Saudi Royals are not much interested in buying bonds created by large U.S. banks, and the banks can no longer make loans to many credit-worthy consumers and businesses. Without credit, the U.S. economy cannot grow and prosper.

The Federal Reserve has direct regulatory responsibility for the large U.S. banks, and it is Ben Bernanke’s job to require them to fix their business practices and resurrect the market for bonds backed by bank loans.

Yet, Federal Reserve Chairman Bernanke has offered no plan to address these problems, or even acknowledged the urgency of the situation. And, without a well functioning banking system, the U.S. economy heads into recession of uncertain depth and duration.

International investors, recognizing the U.S. economy lacks competent helmsmen at Treasury and the Federal Reserve, are fleeing the dollar for the best available substitute--the euro and gold.

When George Bush was inaugurated, the euro was trading at 94 cents and gold cost $266 an ounce. Now they are trading at $1.52 and $985 an ounce. That is a plain vote of no confidence in the Bush–Bernanke economic model.

Peter Morici is a professor at the Robert H. Smith School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles