Wednesday, October 31, 2007

Money, Oil, and China

Once upon a time, the dollar was as good as gold at a fixed price per ounce at the U.S. Treasury. One dollar bills were payable in silver on demand at the U.S. Treasury. Those days are long gone. Now the dollar bill is a piece of green paper that is legal tender for all debts, public and private, in the United States. That it can be used to pay taxes gives it intrinsic value. But its real value depends on its purchasing power, what it can buy. Its exchange value depends on what people holding other currencies will pay to buy dollars. Many factors determine the exchange rate of the dollar, but one thing is clear: The dollar has been falling for reasons posted on this blog, in particular the large annual current account deficit ($800 billion), the federal budget deficit, and other factors.

Most critics point to the large trade gap with China as the bugbear of the weak dollar. The problem with this focus is that it diverts us from the real culprit of oil imports. It does so because it is easier to beat up on China than on countries in the volatile Middle East, Africa, and Latin America on whom we depend for oil. Without their oil, the price would rise to astronomical proportions, from $95 a barrel to perhaps several times that. We cannot afford to offend the oil producers, even if they are the source of anti-Americanism, anti-Semitism, and Islamic extremism. Oil producing states, which import goods and services from Europe and other countries with strong currencies, seek higher prices to compensate for the weaker dollar. The dollar is now at its weakest point in eleven years.

The challenge is to reduce our heavy dependence on imported oil. Many projects and plans are underway, but these are years away from any significant reduction in our consumption of imported oil. Worse, the trends are for oil demand to increase and prices to move higher. India’s energy demand is projected to triple in 20 years. As an increasing number of Indians enter the middle class, demand for cars will rise markedly. In China, auto sales are up 25 percent over last year, and are on track to surpass annual U.S. auto sales sometime in the next decade. Add in Vietnam, Indonesia, Thailand, and other fast-growing economies, and oil demand will continue to rise. Production will not keep pace given the stagnation in output in many of the world’s largest producers. Oil-exporting countries need hundreds of billions of dollars to maintain, renovate, and add new production facilities.

Easy Money

Instead, the markets are focused on the cost of money. Cheap money created the sub-prime loan crisis and concerns over the quality of credit. Many market participants want still cheaper money to prevent further losses and an economic slowdown. Exporters have become major beneficiaries of a weaker dollar as their foreign earnings translate into more dollars. But a weakening currency typically gives rise to inflation and economic stagnation, the condition known as stagflation that marked the U.S. economy in the late 1970s and early 1980s. Perhaps most money managers are too young to remember those difficult times.

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