•°o.O beware the weakening dollar O.o°•

by Donald Luskin
September 28, 2007
SmartMoney.com

SINCE THE FED CUT interest rates by 50 basis points last week, the U.S. dollar has fallen by 1.7% against the rest of the world's major currencies. That may not sound like much, but it's actually a big move in the context of world currency markets. And it's especially notable because it takes the US dollar to a new all-time historic low.

Should anyone be surprised? The Fed's interest rate move was larger than expected, but its effect on the dollar could easily have been forecasted (in fact, I did, repeatedly, in this column). In essence, the Fed's move put more money into circulation to prop up what the central bank expects will be a weakening economy. When the Fed prints more dollars, then dollars become less scarce. So the price of dollars falls, just as the price of apples falls if a farmer produces a lot more apples and apples become less scarce. It's pretty basic economic logic.

And it's also basic logic that when the value of the dollar falls, the price of everything in the world — the dollar price, that is — tends to rise. So we shouldn't be surprised to see the price of basic world commodities like gold and oil make new highs after the Fed announcement, just as the dollar made new lows. Over time, all the prices — in dollars — for all the world's goods and services will make similar adjustments.

Yes, we call that inflation. It's not a good thing.

Yet we often hear market commentators saying it's good for the US economy if the dollar falls. The story goes that this lowers the price of US goods and services on world markets, and makes them more attractive to foreign buyers.

But let's check that proposition against simple logic. Let's say the dollar drops by 10%, so foreigners want to buy more US wheat because it seems so cheap. Farmers will sell a larger quantity of wheat and take in a larger quantity of dollars. But each one of those dollars will be worth less than it used to be — the dollar price of oil and everything else the farmer buys has gone up from his perspective. In the end, has anything really changed?

That depends on who you are. Maybe you'll be a winner, maybe you'll be a loser.
If you are a saver, you will be a loser. When the value of the dollar falls, the value of your savings falls, too. It's that simple. But suppose you are a borrower? Then, when the value of the dollar falls, the value of the debt you must eventually repay falls, too.

So it's not "good for the economy" when the dollar falls. Some people and some industries may end up winning more than they lose. But overall, the economy will suffer from all the costs and dislocations that result from suddenly having the value of the currency in our pockets and in our bank accounts arbitrarily changed.

Yet our government is doing everything it can to make the dollar fall. The Fed, which plays the largest role in determining the dollar's value, has made it clear that nothing is more important than bailing out the housing industry from its subprime lending excesses — and if that means flooding the economy with dollars, and driving the value of the dollar lower and lower, then so be it.
Congress and the White House are, in their own way, making a similar mistake. By brow-beating China to raise the official exchange rate of the Chinese currency, the yuan, they are implicitly saying that the value of the dollar should fall.

But that wouldn't really accomplish anything. If the value of the yuan were to rise, then the price (in yuan) of everything in China would fall. It would be deflation — the opposite of the inflation we will experience in the US because the dollar is falling. So once it all settled out, our dollars would still buy the same amount of Chinese goods that they do today. We can't escape the reality that people in China are simply willing to work for less and sell for less, so their goods and services are a bargain on world markets. It has nothing to do with their currency.

In worrying about a weak dollar, it may seem on the surface that I'm in the same camp as Warren Buffett and others who have warned that the US economy is an over-indebted time-bomb, and that the dollar will eventually collapse because of our profligacy. That's not where I'm coming from. I think Buffett's analysis is utterly wrong. The value of the dollar has almost nothing to do with the strength of the economy.

How come the dollar surged while the economy was weak in 2001 and 2002? How come the dollar fell as the economy strengthened from 2003 to the present? Clearly, there is no relation between economic strength and the value of a currency.

No, it's all about the Fed. It's all about how many dollar bills they churn out of their printing presses, and how many helicopters they use to rain those bills down upon our heads. That's all that matters.

So what do we do now as investors, given that the Fed is gearing up the printing presses and revving up the helicopters?

Again, simple logic. Buy the stocks that are the most immediate and obvious beneficiaries of inflation — energy and basic materials. Those two sectors have been the best-performing since the stock market bottom on Aug. 15, and I think they will continue to be. Export-driven industrial and technology companies should be winners, too, at least in the short run.

But in the end, let's not have a lot of illusions about this. Inflation is not good, and inflation is what we are going to get here. There will be winners and losers, but ultimately we'll all be losers. Someday the Fed will have to jack up interest rates sky-high to stop the inflation it's now causing.

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