How the Dollar Works (and Why Current Policy Will Wreck it and the Economy With It)

Just over a month ago, Secretary Geithner spoke to Chinese university students and they laughed when he suggested that Chinese dollar assets were safe.

Chinese university students are reported as having laughed at Geithner, the US Secretary of the Treasury, when he promised the Chinese students that Chinese assets in dollars are "safe".

Geithner offered inclusion of China in the IMF as he sought multiple ways to engage China.

One of the lesser reported aspects of the trip was Geithner's talk of change in the exchange rate between the Chinese currency and the US's.

In fact, Secretary Geithner was in the Middle East making a similar case just today.

Geithner will seek to reassure Gulf Arab states this week that U.S. dollar assets they hold in large quantities remain a strong investment.

A recent decline in Saudi foreign assets shows the purchase of U.S. Treasurys by Washington's Gulf allies, five having currencies pegged to the dollar, at levels seen in the past decades should no longer be taken for granted.

It's time to address how the Dollar works and how our current policy will affect it and our economy with it.

First of all, Dollars are traded on exchanges along with most other currencies in the world. This means that the strength or weakness of the dollar is determined by just how many buyers and sellers there are at any given time. The market for dollars, however, is very different than say the market for a stock like Microsoft. In currencies, it is a zero sum game. Currencies are traded in relation to each other. Whereas Microsoft can continue to rise with no end, the dollar can only rise at the expense of other currencies.

So, whereas there are periods when most investors make money in stocks, in currency for every winner there is a loser. If the dollar is getting stronger, that means that some other currency is getting weaker. Think of the currency market as a very complicated bicycle. As one peddle goes up another goes down. Only in currencies there are literally hundreds of peddles all going up and or down all at once.

For a currecy trader, all that matters is predicting the relative strength or weakness of a particular currency. In other words, all a currency trader is trying to do is buy the dollar when its weak and sell it when it's strong. For a country, the relationship is a lot more complicated. A weak dollar presents all sorts of challenges. A strong dollar also presents challenges only they are different ones. In fact, I believe that effective policy strikes a balance in the dollar. In fact, Steve Forbes believes that monetary policy should focus on stabilizing the dollar. In other, words he thinks the Federal Reserve should use monetary policy to make sure the dollar doesn't get too strong or too weak.

The dollar and monetary policy:

Let's start with this basic premise, the relative strength or weakness of the dollar is based on the supply and demand of the dollar. What is the primary role of monetary policy...control the money supply. As such, in effect, the Federal Reserve contols the supply of dollars. The more dollars there are in this world, the less each one is worth. So, I've talked a lot about something called "quantitative easing". In "quantitative easing", the Federal Reserve creates money and then uses that to buy securities. By doing so, they pump more Dollars into the economy.

Now, in each of these examples, we all want to assume that everything remains equal. So, now there are more dollars in circulation. Let's suppose the Chinese have not done the same for their currency. That would mean the dollar would get weaker compared to the Chinese Yuan because more dollars are now circulating in relation to the Yuan.

So, while quantitative easing is one way to expand the economy, it's also an effective way to weaken the dollar.

The Dollar and Inflation:

The dollar hates inflation. This is a based on a very simple concept. The more dollars it takes to buy the same good the less valuable each dollar is. If it takes you two dollars to buy a McDonald's happy meal today, but tomorrow it costs three dollars, that makes each dollar less valuable.

The relationship is very symbiotic. Often, it's hard to tell which comes first, the weak dollar or inflation. One can cause the other and vice versa. Each is a precursor for the other.

The Dollar and Interest Rates:

The relationship between the dollar and interest rates is a lot less simple to determine. On the one hand, low interest rates are a reward of currency. In other words, if rates are low in America that will in turn create more demand for dollars since more people are taking out loans here. Furthermore, lower long term rates indicate less chance for infllation, which I just showed would weaken the dollar. Of course, very low rates for too long, like we had in 2001-2003, can lead to high inflation quickly as they are expansionary. So, if they are too low too long, that can boomerang quickly and ultimately hurt the dollar.

As with inflation, and almost everything, it's never clear what is cause and effect. In other words, it's often unclear if low rates lead to a strong dollar or vice versa. In fact, both affect each other in very organic ways and no one knows for sure which drives which.

The Dollar and Commodities:

It's important to understand that almost all commodities are traded in dollars. In other words, commodities like oil, corn, beef, etc. are priced in dollars. In fact, the dollar is the world's currency. This has consequences to both our economy and geopolitics. First, a weak dollar leads to higher commodities. So, a weak dollar makes gasoline and food more expensive.

Since commodities of all shapes and sizes make up significant portions of the economies of countries all over the world, many players in the world have a vested interest in seeing the dollar move in one direction or another.

For instance, in my opinion, the best analysis of Vladimir Putin comes from former chess champion, Garry Kasparov. Kasparov believes that everything that Putin does he does in order to artificially inflate the price of oil, which is a major export for Putin. Well, a weak dollar would increase the price of oil. That might explain why Putin has spent the last six months talking down the dollar and suggesting that it stop being the world's currency. A weak dollar translates into high oil prices which is the major source of wealth in his nation.

Government Policy and the Dollar:

So, how does our current policy affect the dollar? The endless government borrowing absolutely weakens the dollar. The first reason is perception. The dollar is the representation to the world of our economy. In other words, a stronger economy is represented by a stronger dollar. It's a sign of terrible weakness when governments need to borrow excessively. It also leads to questions about how this debt will be paid back. For instance, one way to pay it back is to simply print more money. Of course, the more dollars there are out there, the weaker each one is.

In this case, it is the combination of fiscal and monetary policy that puts double weakness on the dollar. While the government borrows, the Federal Reserve creates money and buys the very bonds used by the government to borrow all this money. Of course, this is no different than the Treasury turning on the printing press and creating the money themselves. In fact, what the Fed is doing now is the 21st century version of printing endless streams of money. It's much easier to type a few keys in the computer screen and create trillions than it is to print them.

So by borrowing trillions and then having the Federal Reserve create them and buy the bonds used to borrow, the government's combined monetary and fiscal policy significantly weaken the dollar.

Effects of government policy:

So, what does a weak dollar lead to? First, it leads, eventually, to inflation. Like I said earlier, the two go together. I also said it's often difficult to tell which leads to which. Yet, it's clear if dollar is weak then it will take more of them to buy stuff. More immediately, it will put upward pressure on commodities. Now, keep in mind, this assumes everything else is equal. If the only thing pulling on oil was a weak dollar it would shoot up. It isn't. We also have a weak worldwide economy and that pulls down on oil. So, we have competing drivers pushing and pulling on oil. Think about this though. We are now in an unprecedented period of economic weakness and yet oil is still trading at $60 per barrel. That has everything to do with a weak dollar.

The most significant effect is that it makes foreign investment in the U.S. less attractive and foreign investment by U.S. investors more attractive. Let's do a quick hypothetical. A Chinese person invests in the U.S. At the time, 4 Yuan buys 1 dollar. Then, that one dollar turns into two but now one dollar only buys two yuan. Their return is zero even though it doubled. The exact opposite effect would happen to a U.S. investor investing overseas. So, a weak dollar would discourage foreign investment and encourage foreign investment by Americans.

That's why Geithner addressed the dollar. He was laughed at because as I showed, our policy is clearly making the dollar weaker and it clearly threatens all foreigners current investment in dollar assets.

On the other hand, a weak dollar enhances exports and weakens other countries imports. Since 1 Yuan would buy more dollars, it stands to reason that a Big Mac or a Ford would become cheaper in China with a weak dollar and vice versa.

That said, the threat of a weakening dollar is one of the main reasons that foreigners have become so reluctant to buy our bonds. Since their investment weakens with a weak dollar, it will take a higher rate to attract foreigners. In this case, a weak dollar, everything else being equal, raises interest rates. Of course, everything else is NOT equal which is why rates are still low despite a weak dollar. Still at some point, everything does become equal and so ultimately our current policies will lead to a weak dollar, more inflation and eventually also higher inflation.