The Dollar "Meltdown"

Who knows more about the economy: Reuters or the Federal Reserve? Reuters is pretty sure that they know more than the Fed.

They are claiming that the current weakening dollar is threatening the US economy with inflation. The Fed and most knowledgeable economists are worrying more about deflation right now. Why the difference?

Reuters is correct in that depreciation can eventually lead to inflation. But to understand why, we need to really understand the mechanics of inflation and deflation.

Simply put inflation occurs when there are too many dollars chasing too few goods. Prices (or production) have to increase in order to keep the demand equation in balance.

Deflation is the opposite. There are too many goods out there and not enough money circulating. Prices (or production) have to drop in order to bring the equation back into balance.

With depreciation, our exports to foreign buyers become cheaper. So they buy more of them, increasing the supply of dollars in the US. More dollars without a corresponding increase in the availability of goods eventually leads to inflation.

So Reuters is right. Depreciation leads to inflation - eventually. And it is the eventually part that makes their advice of defending the dollar a bad idea.

Right now, the bigger threat is deflation.

Our economy has slowed too much. The job market is much, much too soft. Unemployment still isn't too bad, but underemployment - people working in jobs beneath their qualifications - is becoming a real problem. Due to the perceived weakness in the economy, people are unwilling to spend their money on anything besides the basic necessities.

We haven't entered the deflationary cycle yet, but we're coming pretty close. And we only need to look at a decade of economic suffering in Japan to know that we don't want to go down that route.

So how would a depreciatory regime help?

By depreciating the dollar, we make foreign goods more expensive here and American goods cheaper over there. Our imports will decrease and our exports will increase. That means more dollars going to American businesses and hopefully a trickle down effect from there.

The real risk comes in that what we actually accomplish is the exportation of the deflationary threat. Europe will be the primary recipient of the threat, as it is the Euro that has been strengthening the most against the dollar.

As the dollar depreciates, our goods would become cheaper in Europe. The flip side of our benefits is that in Europe, in the Eurozone, it would substantial pressure on the already shaky economies of Europe. If we push Europe into a deflationary cycle, it wouldn't take much to drag us into the cycle despite our efforts to avoid it.

So what to do?

The depreciation route is probably the best option right now. The best hope seems to be to try to jumpstart the US economy before the Eurozone economies collapse under the deflationary pressure. It's an extremely risky path, with a pretty substantial chance of failure. But the alternative is certain deflation.

This is not an election issue like the author of the story is claiming. This is a real threat to the health of the world economy. During the end of the '90s we got too far extended economically; we are now paying the price of our "irrational exuberance." It wouldn't matter who was running the country. It is almost certain that we'd be in this same situation.

It's a risky situation. The chance of failure is high. But at least this time, on this issue of deflation, it sounds like the Bush economic team has their ships sailing in the same direction. They are planning to take on the threat of deflation.

Even if it means depreciating the dollar.