Flagging Faith and Credit

Written By Brian Hicks

Posted November 28, 2006

You may not worship the almighty dollar, but money is as faith-based a paper product as the Good Book is, and it’s causing just as much of a stir after the turn of the millennium.

In foreign exchange trading prior to this week’s stock market opening bells, the greenback took a hit. The European common currency, the euro, reached its strongest level against the US dollar in 19 months. The knock-on effect of this relative slump is far-reaching, with both positive and negative aspects.

To understand the role that the dollar plays in the world economy, you must accept one unsettling fact: the dollar cannot stand on its own.

All those dead presidents in your pocket live on through the power of government fiat. Fiat money cannot be redeemed for anything you can find in the ground or poke with a stick. At least not at the Federal Reserve, where the gold window closed in 1972. What you have is legal tender-money whose worth rests on the comings and goings of the country’s economic strength.

That’s how we got to today. Euro Zone economic growth is outpacing US growth, and is expected to continue the trend in the near term. Investment in the dollar is less attractive than euro holdings because European Central Bank interest rates are higher than the Fed’s.

Central bank interest rates have been the key mechanism for regulating the value of paper money since the rush away from gold. But the dollar is still the international sale standard for the world’s most important goods, like oil, steel, and even the means of transportation that move these precious commodities around.

The post-WWII system of monetary metrics, which we have inherited, set the dollar as the world’s reserve currency, backed by Washington’s growing economic and military wherewithal. The presence and strength of the euro has given a foil to those central banks wishing to hedge their bets against a decline in the dollar and its dominion.

In the meantime, consumers who trade in stronger currencies will reap the rewards of this potential sea change. Just like the euro, the British pound is on a steady 5-year strengthening trend against the dollar, and has reached a 2-year peak recently.

High Time for a Holiday

The BBC reports that the number of people taking flights from London to New York is up 20% over this period last year. British consumers, as well as those from the 12-nation Euro Zone, will continue to flock to lower prices Stateside-a probable boon to our economy, as high-end shopping tourism does somewhat balance retail weakness at stores like Wal-Mart.

British importers who trade in dollars for goods produced in Asia are seeing a unit-cost reduction of as much as 15% based on their currency advantage. The US should seize this opportunity to ramp up production while its own dollar-denominated goods are more attractive to the Europeans, even though the dollar itself is less appetizing.

The model that holds the US worker is the innovator of the world, free from the burdens of assembly-line work that can be done more cheaply overseas, has failed. There has to be a mix of duties and benefits in a diversified global economy.

Since "offshoring" and "outsourcing" became part of our lexicon, the primary export of any real significance that has been generated from the US has been dollar-based debt. The People’s Bank of China, banks in the Gulf Cooperation Council and plenty of others have demonstrated their full faith and credit in the US currency as the international reserve.

Don’t Jump Ship Just Yet

Though the euro is currently more attractive, these countries cut the dollar a lot of slack.

No one wants to see the dollar go into a freefall, and I don’t think it will happen. For its part, the Federal Open Market Commission has its finger on the interest-rate trigger and will not allow the inflationary pressure of cheaper US money to turn into soaring consumer prices.

It will likely raise rates, narrowing the gap again between the stagnant Fed rate and that of the European Central Bank. This will hit the teetering housing market with an unwelcome new blow, but inflation hawks will sacrifice new home sales on the altar of retail.

In stock trading, it may surprise you to know that the initial slump brought on by the stronger euro affected European markets as well as Wall Street. Export-based European stocks were hit hardest, as those companies’ wares are now more costly to important consumers.

US stocks will still maintain their relative value within the dollar world, and there is of course still plenty of money to be made. What that money will be worth, well, that is a different story.

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