Special Edition Best of Five Things: Five Things You Need to Know About the Dollar
Dollars to donuts? We're almost there!
Editor's Note: This article was originally published on May 12, 2006.
Minyanville's five things you need to know to stay ahead of the pack on Wall Street:
Despite reaching levels that are technically oversold, and despite Treasury Secretary John Snow's reaffirmation Wednesday that the U.S. maintains a strong dollar policy, the greenback just can't catch a break. What's going on? What is a dollar? Why do we care whether it goes up or down in value? Isn't the dollar I'm holding today the same as it was yesterday? Why can't the Fed just print more dollars?
1. What is a dollar anyway, what does it mean?
- The dollar is simply a banknote issued by the government of the U.S. that is mandated by law to be used as legal tender for all transactions.
- Although the dollar used to be backed by gold, today it is backed simply by the promise of the government that it will be convertible in an exchange.
- Got faith? Good, you'll need it, because faith is the only thing standing between a dollar bill as exchangeable for say, a banana, and a blank sheet of paper.
2. Ok, Ok, I got faith aplenty, so where do all our dollars come from, and why can't the Fed just print more money?
- The Fed can print money.
- And the missing M3 money supply data (which the Fed abruptly stopped publishing this Spring) suggests they do. A lot.
- But every dollar created dilutes the value of a dollar already in circulation, causing it to weaken.
- Of course, we don't notice this dilution immediately unless we travel outside the country, and if everything we consumed was produced here in America we probably wouldn't notice a weak dollar at all! Yippee!
- Wait, did you see the trade report this morning? The trade report is what we import (buy) compared to what we export (sell).
- D'oh! We ran a trade deficit of $62 billion dollars.
3. OK, so, we're spending more than we're making, and the Fed is printing money to make up the difference. How does the Fed do it?
- The Fed "prints" money through three mechanisms. The easiest way is through the Fed's Open Market Operations. Through open market operations the Fed buys and sells, literally, Treasuries that are trading in the "open market." If the Fed buys Treasuries, then the dollars it uses to buy them become available to banks to lend. If it sells Treasuries, the dollars get taken back.
- The second mechanism is lowering the percent of deposits banks are required to have on hand - thereby increasing the pool of available money to lend.
- The third is through their "discount policy." The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility. The Fed can grow money by reducing the discount rate.
- Dollars are literally printed by the Bureau of Engraving and Printing.
4. Trade deficit, weaker dollar... I kinda get it. The Fed has to print more money. But the more money they print, the weaker the dollar gets. Who is paying for all of this and what's the connection with foreign central banks?
- Because we Americans as a whole spend more than we save, both individually and collectively as a government, that money has to come from somewhere.
- Since the more money the Fed creates, the weaker the dollar gets, how do we get all these dollars to spend without collapsing the currency?
- One way is through the purchases by central banks of countries such as China and Japan.
- We have to "sell" our Treasury bonds to countries willing to buy our debt, paying them interest for financing our spending.
- Foreign governments all over the world also use the dollar as a foreign exchange reserve, allowing them to control their own currency, increasing or decreasing it compared to other currencies, and to maintain stability of their currency in the event of an economic shock.
- Because the dollar is perceived as the most stable currency in the world (note: key word is PERCEIVED) countries are willing to finance our spending by purchasing dollars and bonds.
- But, if they begin to perceive they are not being adequately compensated for the risk of holding our debt, or if their dollars are depreciating faster than they like, these countries will demand a higher interest rate to buy our bonds. So, a weak dollar can lead to higher interest rates! That affects YOU, Mr. Homeowner-credit card spender-businessman-student!
5. Ok, so bottom line this for me. In the simplest terms, what are the advantages or disadvantages of a stronger or weaker dollar?
- Weak dollar - Advantages
- Easier for U.S. companies to export goods because foreign currencies can buy "more" against the weaker dollar.
- Tourism increases because foreign visitors find it less expensive to visit.
- To an extent, foreigners will view investment opportunities here more favorably since they can buy more for their yuan/yen/euro/pound, etc.
- Weak dollar - Disadvantages
- Higher prices for consumers (We don't notice this because the Chinese yuan is tied to the dollar in a tight range and most of our imports come from China - just look at your shirt and your shoes!)
- Higher interest rates, i.e. higher cost of money to consumers.
- More expensive to travel abroad.
- Strong dollar - Advantages
- Lower prices for imported goods.
- U.S. investors can buy foreign assets and investments at lower prices.
- Strong dollar - Disadvantages
- Harder for U.S. companies to compete abroad.
- More expensive for foreigners to visit U.S.
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