Why Dollar's Continued Slide May Undermine Global Status

With the U.S. dollar plunging in value and the threat of runaway inflation on the horizon, the President decided that drastic action was necessary to end rampant speculation on the currency.

AP

"We must protect the position of the American dollar as the pillar of monetary stability around the world," the President declared in a nationally televised address.

With that, Richard Nixon effectively took the United States off of the gold standard once and for all, and on August 15, 1971, ushered in the modern era of free-floating currencies.

While the adjustment was difficult to say the least—inflation gripped the nation anyway—the dollar emerged as the world’s pre-eminent currency, one that any nation had to own if it hoped to trade with the rest of the world.

University of Maryland economist Peter Morici says the dollar is the logical choice as a “reserve currency.”

"You can buy just about anything made in the world here,” Morici says. “Also, the United States is a safe haven for capital."

But now, the American currency is under siege.  It is trading near 14-month lows versus other major currencies.  And there are pointed questions on world markets—unheard of in previous years—about whether the dollar deserves its status as a reserve currency, or whether it should be replaced—perhaps by a basket of other currencies.

What Has Changed?

Budget deficits for one thing, rising steadily through the Bush administration and continuing into the Obama administration. Simply, the more dollars the U.S. prints, the less valuable they are.

Add to that, trade deficits.  The United States imported $30.7 billion worth of goods more than it imported in August, according to the Commerce Department. 

And while a weak dollar helps narrow the trade deficit by making U.S. goods more affordable abroad, the net effect of an unstable currency undermines the arguments for keeping the dollar as the global currency of choice.

Among those pushing for a more stable U.S. currency—and some say quietly calling for an alternative to the dollar—is China, which holds massive amounts of U.S. debt as well as dollar reserves.  A weak dollar not only hurts the value of China’s holdings, but impacts U.S. demand for Chinese imports.

But Morici says China has only itself to blame for keeping its own currency artificially low in order to stimulate its exports. 

"China is torpedoing the value of the dollar," says Morici, who criticizes both the Bush and Obama administrations for not taking a tougher stance against Beijing.

The situation highlights the delicate balance in the currency markets.  On the one hand, the weak dollar is helping to stimulate American exports, helping U.S. multinationals.  That, and the fact that U.S. assets are less expensive to foreign buyers, is creating a tailwind for the stock market.  Besides, some argue the greenback is simply returning to a reasonable level after years of being overvalued.

But a weak currency can have serious long-term implications.  Imported products become more expensive—a weak dollar simply does not go as far.

The price of oil and other commodities is directly tied to the value of the dollar. Not only are they priced in dollars on world markets, but many investors are using commodities as a hedge against dollar weakness. That has sent oil prices sharply higher as the dollar has declined, creating a drag on the economy.

• BP CEO: Dollar Slide is Major Factor Behind Oil's Rise

Longer term, a weak dollar gives the U.S. less borrowing power. That makes financing the national debt more expensive, making the budget deficit even worse, and hurting the dollar even more.

No wonder politicians and policymakers almost universally insist they favor a strong dollar.  But these days, it is proving easier said than done.