November 7th proved to be a very difficult day for our American currency as some Chinese officials, who are not even responsible for foreign exchange policy, commented against the strength of the dollar. One official urged his country to diversify its reserves away from weak currencies such as the dollar while another official stated that as a reserve currency the dollar was shaky. These comments combined with record losses from GM, the eminent threat of $100 per barrel oil and the unstable mortgage industry caused the Dow to fall by 2.6% and the S&P 500 index to fall by 3% on November 7th. The situation grew worse when French President Nicolas Sarkozy, on visit to Washington, told Congress that the Bush administration needed to do something about the strength of the dollar or they might run the risk of an “economic war”.
The real crisis that looms over the U.S. dollar would be realized if the foreign investors in the dollar (mainly the Chinese buying up U.S. debt) should decide to abandon use of the dollar as the key currency causing a collapse of the dollar. This would put our financial markets in jeopardy and the Fed would not be able to cut interest rates as the currency rapidly devalues. This crisis is not currently considered to be likely because the dollars decline in value has not been rapid. The Fed is taking some precautionary measures (or bail outs depending on your point of view) with its cuts interest rates by 0.75 percentage points in the last two months and is expected to cut rates again when it convenes on December 11th. Current concerns are that, in light of the recent Chinese remarks, central banks of nations with emerging economies will turn their backs on the dollar in search of stronger currency. This is due, in part, to the fact that the number of global foreign exchange reserves held in dollars has decreased in the recent years. It is unlikely that a change of this magnitude would happen rapidly as central banks would be hesitant to make such a large change to their reserve portfolios.
In the United States hits to the dollar’s value have caused little concern. There has been little indication of dramatic changes in price pressures or inflation. In fact, the lower value of the dollar has increased the amount of exports and thus increased the amount of capital inflows. (thank you international economics) This caused our national current account deficit to fall to 5.5% of GDP in the second quarter from 7% at the end of 2005. As of now it appears that the dollar crisis is not too great a threat and we are actually enjoying some benefits from our dollars current value.