Will the U.S. Dollar continue to fall?

Due to the uncertain consequences of fiscal policies being pursued, in addition to the global financial imbalances—as evidenced by the U.S. current account (trade) deficit—we foresee the structural issues that have contributed to the weakening dollar may not dissipate but rather evolve. We cannot predict with certainty that the dollar will in fact decline; however, we present an overview of economic forces permitting you to assess whether a basket of hard currencies, such as provided through the Merk Hard Currency Fund, is a valuable diversification element to your existing portfolio to protect yourself against a further decline in the U.S. dollar.

In 2008, the trade and current account deficits continued to reach levels of approximately 5% of gross domestic product (GDP). Many economists do not believe this is sustainable. The question is how the large current account deficit will be reduced. The primary options typically discussed include an increase in domestic savings, an increase in foreign consumption, or a lower U.S. dollar.

Domestic savings

The U.S. household savings rate was 3.2% at the end of 2008, compared to Chinese households that saved over 25%. The U.S. is a consumption machine, with about 70% of GDP due to consumer spending, up from about 50% in the early 1990s. An increase in savings would mean a decrease in consumption, i.e. a recession, unless real incomes are going to rise substantially.

Can we expect real incomes to rise? Consider this: U.S. corporations have little pricing power because the market is flooded with inexpensive imports from Asia, and because U.S. consumers are heavily in debt. Conversely, U.S. corporations face high raw material prices as U.S. and Asian policies cause global over-production: Asia causes overproduction by subsidizing their exchange rates; the U.S. is contributing to overproduction through monetary (low interest rates) and fiscal (lower taxes) policies. U.S. corporations are left with little choice but to accelerate their outsourcing, so that they can reduce their remaining variable cost: labor. This explains why we have had relatively disappointing employment growth while GDP growth has been respectable. While wage pressures are going to increase, we do not see how substantial real income growth will occur to reduce the current account deficit.

Instead, the current account deficit could be reduced through a tax on consumption, e.g. through a national sales tax. One has to watch political developments, but a national sales tax is not popular with voters, or with businesses, or with municipalities.

Increase in foreign consumption

Policy makers in the U.S. would love to have the trade deficit adjust by an increase in foreign consumption; this would be the most benign way to unwind the global imbalances. The world economy continues to be highly dependent on U.S. consumer spending. As we have witnessed, a recession in the U.S. has the capacity to pull down worldwide economic growth. There may be a time when intra-Asian trade and European growth can offset an economic downturn in the U.S., but that won't be anytinme soon.

Even when consumption in the rest of the world picks up, it is unclear how much of that growth will be derived from trade with the U.S.

Lower dollar

Currency devaluation tends to be associated with significant trade and current account deficits, but a lower currency doesn’t fix the imbalance. We saw this in late 2003 and early 2004, when despite a lower U.S. dollar, we had higher trade deficits. We believe that the weight on the dollar will not go away unless structural changes take place that will increase domestic savings and/or lower domestic consumption.

Next: How can I protect myself from a falling U.S. Dollar?