The Dropping Dollar

It’s getting hard to miss the decline of the U.S. dollar. As an American living in Japan, I keep a close eye on exchange rates and have watched the value of a dollar drop from 125 yen in June 2002 to its current value at around 109 yen. That’s a 13% drop. During the same time period, the dollar fell 15% against the Euro and 11% against the Swiss Franc. You can check the latest rates here.

This is great news for me and others like me who have assets in non-dollar currencies. However, we’re in the minority of Americans. If you’re like most Americans, you save dollars in a bank and move some of those dollars to a brokerage where you buy dollar-denominated investments.

You can change that, though, and make money off what appears to be a solid downtrend in the greenback. I’ll come back to how you can profit in a moment. First, let’s take a look at the evidence behind our sinking currency.

The reason the dollar is falling is that the full faith and credit of the United States is weakening under a growing budget deficit and enormous debt. Our country is $7 trillion in debt. The lenders are getting nervous about the increasingly precarious financial situation of the United States. Therefore, they demand higher payment on their debt. What they are owed are dollars, however, not a specific profit level. The simple solution for the government is to print more of those dollars, thereby lowering the value of each one and making the impact of the staggering debt load less forceful. The U.S. is awash with cash these days thanks to the low interest rates maintained by the Federal Reserve. So, we have a shaky credit foundation and dollars that are worth less every day.

Meanwhile, President Bush is cutting America’s income by reducing taxes and increasing America’s spending. From The Economist:

For all his rhetoric about keeping Washington in check, Mr Bush, as one Republican analyst puts it, has been spending like “a drunken sailor”….The combination of a sharp economic slowdown, tax cuts and higher spending has transformed America’s budget. When Mr Bush ran for office, the fiscal surplus was 2.4% of GDP, one of the highest among big rich countries. By fiscal 2003, the budget deficit had reached 3.5% of GDP. Next year, by official forecasts, it is expected to reach 4.3%….In their most recent poll, members of the National Association of Business Economists described the federal deficit as the biggest problem facing America’s economy. A bipartisan coalition of three economic think-tanks — the Committee for Economic Development, the Concord Coalition and the Centre on Budget and Policy Priorities — recently declared that, without a change in course, the next decade might be the “most fiscally irresponsible” in the country’s history.

Some of the smartest investors in the world noticed this trend in the past year or so and have moved into investments pegged to non-dollar currencies or have taken short positions against the dollar, betting that it will move lower. The two investors I’m thinking of most are George Soros and Warren Buffett.

Here are some excerpts from an article Buffett published in the October 26, 2003 issue of Fortune:

Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in — and today holds — several currencies. I won’t give you particulars; in fact, it is largely irrelevant which currencies they are. What does matter is the underlying point: To hold other currencies is to believe that the dollar will decline.

Both as an American and as an investor, I actually hope these commitments prove to be a mistake. Any profits Berkshire might make from currency trading would pale against the losses the company and our shareholders, in other aspects of their lives, would incur from a plunging dollar.

But as head of Berkshire Hathaway, I am in charge of investing its money in ways that make sense. And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country’s “net worth,” so to speak, is now being transferred abroad at an alarming rate.

Our annual trade deficit now exceeds 4% of GDP. Equally ominous, the rest of the world owns a staggering $2.5 trillion more of the U.S. than we own of other countries. Some of this $2.5 trillion is invested in claim checks — U.S. bonds, both governmental and private — and some in such assets as property and equity securities.

In effect, our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4% more than we produce — that’s the trade deficit — we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.

To put the $2.5 trillion of net foreign ownership in perspective, contrast it with the $12 trillion value of publicly owned U.S. stocks or the equal amount of U.S. residential real estate or what I would estimate as a grand total of $50 trillion in national wealth. Those comparisons show that what’s already been transferred abroad is meaningful — in the area, for example, of 5% of our national wealth.

More important, however, is that foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners’ net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding — goodbye pleasure, hello pain.

We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that’s the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades.

The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary — and because we are so rich. Neither our capacity nor our intention to pay is questioned, and we continue to have a mountain of desirable assets to trade for consumables. In other words, our national credit card allows us to charge truly breathtaking amounts. But that card’s credit line is not limitless.

The dollar is weakening and smart people have taken action to profit from that trend. But how long can the trend last?

According to Everbank, quite a while. Two key observations emerged from its look back at the past thirty years of the dollar versus the Swiss franc and Deutsche mark:

  • The first weak dollar trend of the period began in 1971 and ended in 1978, 7 years in duration. During that period, the Swiss franc gained 186% versus the dollar. The Deutsche mark gained 53% during the same period.
  • The next weak dollar trend began in 1985 and ended in 1996, 11 years in duration. During that time, the Swiss franc gained 138% versus the dollar. The Deutsche mark gained 53%.

    It appears likely that the dollar has farther to fall. There are steps you can take to profit from it. The easiest is to invest in gold.

    The dollar, like all paper money, is fiat currency. That is, it has no intrinsic, real worth. It’s just paper and it has value in transactions only because we all agree that it does. You accept a twenty-dollar bill from me because you know that the grocery store will accept it from you. We are all aware of the rough value of twenty dollars. It will buy a book, two movie tickets, a bag of groceries, or a small tank of gas. When you remove it from the U.S. economy, however, its value fluctuates widely as do the values of other currencies when they’re removed from their respective economies. Why? Because fiat currencies are not redeemable for anything other than faith in their purchasing power. They’re worth what we all agree at any given time that they’re worth. A year ago, a dollar was worth 125 yen. Today it’s worth only 109 yen.

    Unlike paper currency, gold has intrinsic value. There is only so much of it on Earth and it can’t be manufactured out of thin air. No government can print more gold. If you own 1% of the world’s gold today, you’ll still own 1% of it in one hundred years.

    Which is why in times like this, when the value of the world’s leading currency is on the descending slope of the mountain, gold becomes more attractive. When higher interest rates return to the dollar — and they will — an ounce of gold will be worth more dollars than it is worth today.

    This constant purchasing power of gold is time-tested, much more so than our dollar standard which has been in place only since 1971. Prior to that, the U.S. was on the gold standard where each dollar was backed by deposits of the metal. Now, dollars are backed by nothing. Gold, however, maintains its purchasing power. Saint Joseph could buy a suit of clothes for an ounce of gold. Two thousand years later, so can you. Today, an ounce of gold is worth about $390. Five years ago, it was worth about $290. See the trend? Nobody knows where it will be five years from now, but the smart money is betting that it will be significantly higher. Why? Because as the value of the dollar declines, the value of gold in relation to the dollar will need to rise because gold always keeps its purchasing power. A suit of clothes costs you $400 today, but tomorrow it will cost you much more. Almost certainly, an ounce of gold will sell for more than $500 in the next few years.

    Which is why gold and gold-related stocks and/or mutual funds would be wise investments during this time. The simplest would be a mutual fund specializing in gold stocks, such as Scudder Gold & Precious Metals (SCGDX). It has averaged a return of 45% a year for the past three years and is up 71% in the past one year. It’s available through Schwab’s no-load, no-fee network. There are dozens of other gold funds as well, but this one tops the list.

  • This entry was posted in Uncategorized. Bookmark the permalink. Both comments and trackbacks are currently closed.
    • The Kelly Letter logo

      Included with Your Subscription:

    Bestselling Financial Author