No crisis for the US dollar -- yet

By Jim Jubak

Will the U.S. dollar collapse under the weight of all the paper money now being printed in Washington to pay for bailing out Wall Street, Detroit and Main Street?

Not in 2009. Surprisingly, the dollar is likely to appreciate in value this year.

But in 2010, the bill for this current crisis will start to come due, and the dollar will resume the long-term downward trend that took the world's reserve currency down 60% against the euro between Dec. 4, 2002, and April 22, 2008. At the beginning of that period, it took one U.S. dollar to buy a euro. By the end, it took $1.60 to buy a euro, according to data from the New York Federal Reserve.

A dollar rally in 2009? If you look just at the troubles facing the dollar, that doesn't make sense. The U.S. economy, financial system and currency are in deep trouble.

The minutes from the Dec. 15, 2008, meeting of the Federal Reserve's Open Market Committee paint a depressing picture of U.S. economic health:

• Payrolls continued to fall and at a faster rate than earlier in the year, pushing unemployment to 6.7% in November.

• Industrial production fell in November, and indicators pointed to a deeper downturn in production in the coming months.

• Consumer spending fell for the fifth straight month in October.

• The home-building industry showed no signs of hitting a bottom as housing starts and housing permits plunged.

• The trade deficit climbed in October as U.S. exports to a slowing global economy fell faster than imports by the slow U.S. economy.

• Looking forward, the Fed projected that the U.S. economy would contract for 2009 as a whole.

Yep, looking just at that picture, you'd have to figure the U.S. dollar would sink like a stone.

Instead, the U.S. currency has rallied since that April low of $1.60 to the euro. By Oct. 28, it took only $1.25 to buy a euro. And though that date marked the 2008 high for the dollar, the U.S. currency still finished the year at $1.40 to the euro. That's a gain of better than 12% for the dollar, even as the U.S. economy and our financial markets have raced toward disaster.

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But currencies don't get stronger and weaker based on the absolute health of the underlying economy and financial system. Currency moves are a result of relative changes. And that's what saved the dollar from a collapse in 2008. As bad as things were here, they were worse in the rest of the world.

Other currencies even less popular

As the global economy slowed, for example, investors and businesses rushed to dump Brazilian reals, Russian rubles and South African rand, and assets such as stocks and bonds denominated in those currencies.

It's not that they loved the strength of the U.S. economy or believed deeply in the U.S. financial system. They simply concluded that the dollar was safer. Although the U.S. economy might contract by a few percentage points, they reasoned, it wouldn't collapse. And while a U.S. bank or two (or three) might fail, the U.S. government wouldn't suspend trading in its currency or make it impossible to withdraw assets.

So in the flight to safety, the real fell more than 40% against the dollar from April 22 to the end of 2008. The ruble fell 26% against the dollar, the rand 22%.

To get a sense of how strong the fear that drove the flight was, consider this: Investors were more than willing to buy the safest dollar-denominated assets -- U.S. Treasury bills -- even though the yield on those bills was almost zero.

The flight-to-safety phenomenon doesn't explain why the dollar would rally against the very safe and stable euro, though. Here, a different kind of relativity led to an appreciation of the dollar against the European Union's common currency.

A bad path, but further along

Investors and currency traders have apparently decided to favor the dollar because the U.S. economy went into its slump more quickly than did Europe's economies, especially Germany's. You might think that would depress the dollar against the euro, but in the last half of 2008 it worked in the opposite direction.

Because the U.S. economy went into its slump faster, it should be the quicker of the two economies to recover. Following that logic, even the Federal Reserve's December decision to cut its target short-term interest rate to near zero is a plus. The Fed, you see, is closer to the end of its interest-rate cuts than is the European Central Bank.

The European Central Bank is expected to cut interest rates by a quarter of a percentage point, to 2%, at its Jan. 15 meeting. That will still leave the bank lagging 1.75 percentage points behind the Fed. So investors and traders, looking ahead, worry the euro will continue to weaken as the European Central Bank cuts rates over the next six months to fight a deepening European slump.

Taking the comparison further, the United States is doing more to end its recession faster than the Europeans are doing to deal with theirs. The incoming Obama administration is planning on a $700 billion to $800 billion stimulus package of tax cuts and government spending to jump-start the U.S. economy. The United Kingdom's big move has been to cut its value-added tax on goods and services. Germany lags even further behind, with the Merkel government still resisting the idea of increasing deficits to finance a big spending package to get its economy moving.

Continued: Once the crisis passes

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