How Low Can the Dollar Go?

By Martin Hutchinson

At midday Monday in New York, the euro stood at a record $1.3844 against the dollar, while the pound had risen to $2.0625, a level not seen since 1980. And it was only briefly seen at that. The pound was only consistently above $2 before the high British inflation of the 1970s. So what’s happening; how far can it go; and does it matter?

Economists will tell you that exchange rates are governed by “purchasing power parity,” in other words that they will fluctuate around a level at which costs are the same in the two countries. That’s pretty well complete nonsense.

Year in year out, the United States is cheaper than most of Europe, for most things. Decade in, decade out, Japan was ludicrously expensive, then in the 1990s it became quite cheap. Emerging markets with open trading systems and low labor costs are often very cheap places to live, especially if they have weak currencies.

I can vouch for this personally. When I was in Britain this summer, I did almost no souvenir hunting – everything was much cheaper back in the U.S. Back in my banking days, the accounts department used to get bent out of shape whenever I ate more than a hamburger in Tokyo, because the cost would have fed four people at Lutece. In Bulgaria in the early 1990s, currency collapse brought with it some real bargains – at one point you could get very good seats at the Sofia opera for 50 cents.

Part of it is down to distribution costs and tax. The U.S. has the most efficient distribution system in the world, so even when two items are internationally traded, and have the same wholesale price, their cost to consumers will be lower in the U.S.

Furthermore, most European countries have value added taxes around 20%, whereas U.S. sales taxes are only 5-8%. For example Sony Playstation 3 video game consoles sell for $599, plus say 8% tax or $647 in the US and 599 euros ($833) including VAT in Europe.

Thus, purchasing power parities don’t really work; only in extreme cases or between closely neighboring countries (where cross border smuggling taxes place) do they cause prices to equalize.

Since purchasing power parities don’t work, and the US is running a huge balance of payments deficit, there’s not much limit to how high the euro might go against the dollar. $1.50 is easily possible, and it could go quite a bit further. $1.70 or $1.80 is not at all unlikely, but $2 is perhaps too extreme, except for a very short period – at that point European companies would be facing huge difficulties in the US market and transatlantic smuggling would be rampant.

Asian currencies haven’t gone up much against the dollar – in the last year the Chinese yuan is up about 5% while the Japanese yen is down 3%, and both countries are running thumping balance of payments surpluses. Visitors to China will tell you most things are cheap there, but that doesn’t actually mean the yuan should soar – it’s a much poorer country than the U.S., so you’d expect things to be cheap.

However, Japan is more or less as rich as the U.S. Furthermore, the Bank of Japan has been holding interest rates artificially low for several years now (they’re worried about deflation) so international speculators have been making money by borrowing yen and lending in higher yielding currencies such as sterling or Australian dollars. That’s had the effect of holding down the yen artificially.

Those factors combine to make me think that when the yen moves it could shoot up against the dollar, maybe by 20-25% in a few weeks as speculators panic and unwind their positions. Other Asian currencies too could well be strong against the dollar, because their current trade surpluses give them more leeway than the EU, whose trade is more or less in balance.

So what does this all mean: For US-based investors, that means that European investments may be good to hold, because currency movements may help you, but Asian investments, particularly Japanese should be even better. The only caveat is to avoid stock markets like China that are themselves currently in full “bubble” mode.