The US dollar seems to have undergone several ups and downs with the advent of the global financial crisis. It appreciated when the US economy was in the dumps defying usual laws of economics. This appreciation was due to the onset of risk aversion as investors pulled out of risky securities and moved their capital into the shelter of US treasuries. Now when there are signs of economic recovery, the dollar seems to have been depreciating, again in defiance of principles of standard economics. This time around investors seem to pulling out of the safe haven of US treasuries and buying various currencies leading a general depreciation in the dollar.
But now, a larger problem seems to be casting its shadow on the long term strength of the US dollar. The ravages of recession have led to the US deficit to balloon from $459 billion in 2008 to over $1.8 trillion at present. To fund this, the government will have to resort to a massive borrowing program. As the government sucks liquidity out of the economy, interest rates are likely to rise. This can translate into rising costs for conduct of business and have an inflationary impact. This can erode the long term strength of the dollar and lead to its depreciation. It may also be noted that a rise in interest rates can slow down recovery in the US real estate sector, which was the original trigger for the current recession.
Added to this is an uproar in other nations like China and Russia, which have been openly voicing their concern over the dollar as a reserve currency and have been hinting at diversifying their currency holdings in favor of other currencies like the Euro or even gold to some extent. Countries like China and Brazil have even explored the possibility of bypassing the use of dollar for trade between the two nations and settle account in their domestic currencies. China has also proposed the elevation of the IMF currency, SDR (Special Drawing Rights) as a reserve currency to gradually replace the dollar. If some of these measures are put into practice, demand for the dollar can weaken and lead to an erosion in its value.
To undo the impact of the rising fiscal deficit, Obama has made promises to slash the fiscal deficit by half in four years time. However, that would still be larger than what Obama lashed at Bush for. But, then one also needs to factor in Obama promises of universal health care, tax cuts for all but the rich and so on. As an interim solution, Obama is attempting that the Congress adopt a pay as you go plan, under which the government would be obliged to either raise taxes or cut some outlays for new spending. However, Obama’s task seems to be tough as an ageing US population will require more expenditure on old age pension and healthcare. Fiscal profligacy simply means borrowing now and burdening future generation with the debt. But, with an ageing US population, this seems to be an unwise solution and reduction in the fiscal deficit should be a key priority of the government.
Thus, the long and short of the dollar is that while it would continue its short run gyrations based on factors like emergence and disappearance of risk aversion, one of the key factors that determines its long term strength is the fiscal deficit of the US and how it is managed in the future.