Finance Made Easy

Since October 9, 2007, when the Dow Jones Industrial Average hit its all-time high of 14,164, it has lost over a third of its value, falling 40.8% in just over a year to close at 8,378.95 this week (Friday, October 24). In the third quarter of 2008, consumer spending is anticipated to decrease for the first time in almost 20 years (Full of Doubts, U.S. Shoppers Cut Spending - New York Times-Oct. 5, 2008). Meanwhile, the dollar is stronger than it’s been in 18 months, having risen 19.4% against the Euro since its recent low in mid-July.

A friend of mine recently asked me why this is the case, after I mentioned to her that if I were to travel abroad now, I would receive 2.11 Brazilian Reais for my dollars, compared to the 1.65 reais I got out of the ATM when I visited Rio de Janeiro back in February. She expected that the US dollar should decrease in value as a result of the current economic turmoil, which began in the United States. Common sense would seem to agree with her. After all, we are at the center what is potentially the worst financial storm since the Great Depression – why should a significantly weakened economy translate into a stronger dollar? The reason is two-fold.

The first part has to do with the fact that this is a global crisis, not just one confined to the United States. Before the current downward spiral, the global economy had been doing well, thus providing a greater range of investment opportunities outside the United States. With more options available to them, currency traders took a closer look at the US economy. Troubling economic indicators, such as the rapidly widening trade deficit, gave foreign investors cause for concern, and led them to push down the value of the dollar. Now that much of the world economy is in turmoil, investors no longer have the liberty of scrutinizing so closely and have gone back to the basics in search of the safest haven they can find for their money. Since the First World War, and especially after World War II, this has tended to be the US dollar and dollar-backed securities, such as US government bonds and Treasury bills.

Part of this stems from the fact that so much of the world’s business is conducted using the dollar. Rap stars like Jay Z may flaunt foreign currency in music videos and the Giselle Bündchens of the world may demand their modeling contracts payable in Euros (Rapper Jay-Z dissing the dollar - BBC News-Nov.16, 2007) but many transactions, from international trade agreements and intergovernmental loans to arms deals, are still conducted with US dollars. Furthermore, since the Bretton Woods Agreement after World War II (Bretton Woods System - About.com) the dollar has been the world's de facto reserve currency, most recently comprising 63.9% of total foreign exchange reserves in fiscal year 2007. What all this means is that both multinational corporations and governments throughout the world are extremely vulnerable to a collapse of the dollar, to the point that such a collapse could potentially trigger crumbling of the whole global economic infrastructure.

Trillions of dollars worth of transactions would be markedly distorted and much of the world's foreign exchange reserves would plummet in value toward worthlessness. Thus, ironically, the dollar's continued stability is supported in part by the threat of its instability. Much the same way that neither the United States nor the Soviet Union could afford to launch a nuclear warhead at each other during the Cold War for feat that their enemy would retaliate in an equal or greater fashion, resulting in mutually assured destruction, the rest of the world cannot afford to let the dollar fail given the risks of what might befall everyone else if it does. What this essentially means for investors is that if the US dollar is not a safe haven, then no place is.

The second component of why the dollar is increasing in spite of the havoc in the markets actually has to do with the fact that this crisis began in the United States. This may seem counterintuitive at first, but think of it this way: when an epidemic hits a community, the first person to get sick, the one who may even have infected everyone else, is also often the first person to recover, while the rest of the people who were infected later remain under the weather. Similarly, because we started this and thus suffered first the effects of the subprime mortgage crisis, investors anticipate that we will be the first to bounce back.

In 2007 when the subprime mortgage meltdown first began, through 2008 when it was still confined largely to the United States, the dollar continued to fall relative to other currencies, reaching a low point around mid-July 2008. As Russia and various countries in Europe and Latin America began to get "sick" too, resulting from their contact with "infected" institutions like Fannie Mae and Freddie Mac, banks like Lehman Brothers, and poisonous mortgage-backed securities themselves, which had been packaged and sold as exotic, high-return investments abroad, investors realized that these economies were at risk and they fled in search of safer ground. Countries with stable economies that have remained largely sheltered from the brunt of this storm, such as Japan, have not seen their currencies decrease. In fact, over the three month period from July 15, 2008 to October 15, 2008 while the US dollar was increasing in value against the Euro, the Japanese Yen actually rose 5.3% on the dollar.

As the United States was the first country to get hit by this crisis, the presumption is that it is closer to the bottom of how bad things will get than other countries that are still early on in the cycle, and which theoretically have farther still to fall. Investors expect that by putting their money into the US dollar and dollar-backed securities, their investments will regain some of their value sooner than if left in European and Latin American markets.

It remains to be seen of course whether this strategy will pan out for traders. However, given the steps that the United States government has already taken to shore up its economy – increasing the limit of federally insured bank deposits from $100,000 to $250,000, passing the $700 billion financial bailout package, and most recently, directly infusing banks with $250 billion in capital to be used for making loans and buying weaker banks – it is a good possibility that betting on the dollar will work out for investors. The downside for the United States is that once this crisis is over and everything is back to “business as usual,” investors will once again begin taking a closer look at our widening trade deficit and exorbitant and skyrocketing national debt. That will have the potential to drive the dollar back down unless these issues too have been tackled in the meantime, alongside those directly affecting the current crisis.