Why the US Dollar Will Likely Remain Weak for Some Time

U.S. Borrows, China Lends

The U.S.-China trade dynamic has become all the more complicated at a time of soaring Washington borrowing, creating a revolving door of dollars, which may even put further pressure on the U.S. currency.

The U.S. buys cheap Chinese exports with dollars and China uses those dollars to buy billions of dollars of cheap Treasurys, essentially facilitating more U.S. borrowing.

This has been going on since the presidency of George W. Bush, when the deficit-to-GDP ratio matched Reagan-era levels of 6 percent. Given the financial crisis and the Bush and Obama administration policy responses, that ratio is now about 10 percent.

There were howls during the Reagan years, but there were two key differences then: the strength of the dollar and the identity of the Treasury buyers.

“It’s a much more unstable and dangerous world,“ says Jim Rickards, senior managing director at Market Intelligence “The single biggest difference is that in the 80s our creditors were Japan, Europe and the Arabs. All were utterly dependent on us for their security; our national security was their national security. [China doesn’t] depend on us for national security. We don’t have the lever to keep them in line economically, in effect force them to buy Treasury securities.”

The symbiotic relationship between the U.S. and China and its impact on trade flows, investment and exchange rates should be of greater interest to the other key players in the global economy.

Economist after economist called it unsustainable.

The twin deficits, say economists, are something that makes people want to sell the dollar, weakening it further.

Policy Vs Politics

Over the years prior to the single European currency, German exporters, for instance, howled when the dollar was too weak against the Deutsche Mark; their tolerance level with the Euro/dollar rate is now thought to be 1.55, which is not far from the pre-crisis level of 2008. At roughly 1.48, now the dollar is down about 25 cents since March.

American business, however, isn't complaining, especially. S&P 500 companies derive almost half of their sales overseas. Mid-sized exporters are also benefiting.

"The dollar is definitely competitive now and we are seeing our exports beginning to pick up," says Vargo.

And though trade may not be the job engine the housing and financial sectors were in recent years, it is certainly producing jobs—and at a time when the economy is losing more jobs than it creates every month and the unemployment rate is in an uptrend.

Those most worried about the dollar policy think the Obama administration and/or the Fed can and should do something about it. Currency market intervention, however, has been rare and limited in the past decade.

Bernanke surprised the markets recently by addressing the weak dollar, which seemed to put a floor under the currency—at a level not too different than when the central bank boss last addressed the subject in June 2008, as crude oil was pushing $200 a barrel.

“As long as the decline is orderly, the Fed thinks it is a necessary part of the global readjustment,” says Mickey Levy, chief economist at Bank of America.

For now, words not deeds will probably suffice for policymakers. What's to lose other than a little more value?

Economists say speculation about the dollar losing its place as the world's reserve currency is  is wildly premature.

For one, "there is no alternative," says Brusca.

In addition, reserve-currency changes are multi-decade events, as when the dollar replaced the British pound after WWII, when its economic and military superiority were entrenched.

Such a shift would probably also require major political developments, such as the creation of a European republic—well beyond the current economic and monetary union—or a democratic China with a free floating yuan.

Economists say there should be more pressure on Beijing than the U.S. to do something.

"The dollar over the next year or two will tend to see downward pressure because our recovery will be fragile and uneven, and consumers will spend less than they usually do," says Jones. "That's why this adjustment is going to be so be so brutal.”