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Why the US dollar has fallen: Part 1

By Martin Davies

15 June, 2008

Why the US dollar has fallen: PART 1

If you want to boil a frog as the saying goes you put it into cold water and raise the temperature slowly for if you throw a cold frog into hot water it will leap out. The US dollar is such an animal and over the last few years there has been some speculation on the deprecating value of the dollar but such talk until lately seems to have been background noise.   Like our boiled frog, until the temperature raises too high no one notices, but in the last five years the US dollar has depreciated against the Euro by 35%.

In this three part series we are going to look at what has caused the US dollar to collapse, how this affects international trade and what a business can do to protect itself but before any of this and to understand how the world found itself in this mess, we have to look back in history just a touch.

"A nation taxes its own citizens, while an empire taxes other nation-states" writes Krassimir Petrov and is probably the best summation I have read on what brought us to this place today. In the Early 20th Century the US dollar was tied to gold and so the value of the dollar would be entirely pegged to that of the commodity however after the great depression there was a spout of inflation and with an increase amount of currency in circulation the Roosevelt government was forced to decouple the dollar from gold, well nearly decouple. Some years had to pass until 1945 when the Bretton Woods agreement was engaged and other governments could impress on US reserve that the dollar be convertible to gold on demand.

During the years of the Second World War of course the US had supported many of its allies and been insisting on gold as payment so its reserves of the commodity were bountiful.
What is important about all of this is that up until recently the US currency has been looked at by the rest of the world as the reserve currency of the world.  It's a perception, but such a strong vista in that a convertible paper (paper for goods) has base value and the US dollar became the status quo underline on a quote in trade.  If the dollar supply was kept in the value range of gold this perception would have been real but during the Vietnam War the supply of the dollar volume was increased to finance the extension of US forces overseas and the currency was handed over to foreigners in huge volumes in exchange for imported goods and the catch here is; without the ability to buy the currency back at the same value.  In 1970 when foreign governments demanded payment of dollars in gold the link between the US dollar and gold was "severed" and the US would be in debt to the world.

So why didn't the global community unwind at that point?
In 1971 the US government made an agreement with Saudi Arabia for accepting US dollars for oil a resource that the rest of the world was addicted on and when the remainder of OPEC followed by settling oil contracts in US dollars there was a reason to hold the currency and the switch from gold to oil was achieved.  The currency in effect had moved from one base commodity to another.  In today's market this is a significant link and as the dollar weakens the price of oil is going to have upward pressure, there are many of those in the markets that are saying we don't have an oil crisis, we have a dollar crisis. It is important to note that the market place is much more complex than this and that rising prices of oil are due to many factors, some of which are indirectly orbiting around currency differentials and some of which are positive feedback loops.   One would expect for example that as the price of oil raises (in USD terms) the demand for such a commodity would fall off however oil is "a necessity" rather than "want to have" for the commercial world so price increases are generally passed on in the value chain and become inflationary catalysts for the consumer. These inflationary measures often end up contributing to the cost of imported goods where US dollars are sold for another currency and add to the bottomless hole of the US trade deficit.  We'll look at oil and trade deficits in detail later the big question here apart from positive feedback loops, is; why is the dollar falling?

Well fundamentally what broke the dollar away from gold to oil is perhaps the same cause that has driven its deflation this time, war.  Instead of Vietnam in this case it is Iraq. The irony in it all is that Saddam Hussein demanded Euro as a settlement currency for his oil and that a war with Iraq stood to free Iraq from his grip perhaps a good thing and protect the sovereignty of the dollar even though engaging such an act would put the very currency at risk.  The underlying problem with the dollar lies with the large federal budget deficit and the huge growing trade deficit.

In our next article, we are going to look at the implications of a weak US dollar on the global economy and why the dollar is struggling to recover.

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