The year 2007 will be remembered for a long time as the year in which the US dollar fell sharply in value and the US economy faced a crash in the housing sector.The dollar hit a new low of 1.4966 to the euro Friday and everybody is asking how much further it will fall and what is the Fed going to do about it. The worst affected by the fall are China, Saudi Arabia and Japan as these countries have the largest dollar holdings.The value of their huge dollar denominated assets has already shrunk dramatically this year.China and Japan are export driven economies and the falling dollar is hurting exports. Talking of exports even the EU nations are affected by a weak dollar.The US on its part seems to be content to let the dollar decline in value as long as the fall is orderly.In fact its exports have benefited immensely from the dollar weakness, rising 15% in the last 12 months, while prices of imports,except oil, have not risen in proportion as the exporting nations have been reluctant to increase prices in order to protect market share.The only section of the population to have been adversely affected are those traveling abroad for whom a decline in the value of the dollar translates into a decline in purchasing power.
At the recent OPEC summit in Riyadh, Iran And Venezuela called the dollar a worthless currency and floated the idea of an alternative currency.Although their remarks were certainly to spite the US, other nations like China,Japan and those in the Middle East seem to be quietly diversifying their holdings, although there is no large scale sell off of dollar denominated assets as yet.
Bob Shiller in his book 'Irrational Exuberance' (2nd edition) has analyzed home prices in the US for the last 120 years. For 100 years they were almost flat with spikes of 10 to 20% on either side. Then starting in 1997 home prices shot up by 93% in real terms.Part of the rise can be explained by demography, rising incomes and low real interest rates.. But they basically went up because loose credit and easy money created a bubble.The problem with bubbles is that you don't realize you are in one till it bursts.Suddenly prices started falling last summer and the trend is getting worse by the day.Although the supply of new houses has fallen the demand has fallen even more creating excess supply. Add to it about 2.2 million homes the banks will be saddled with due to foreclosures and there will be further downward pressure on prices.Slowing credit to the sub prime sector contributes to further slackening of demand and fall in prices. About $ 1 trillion in ARM's is expected to reset next year. Many people will not be able to afford the higher interest rates and will be forced to sell at depressed rates. It has to be remembered that a large part of the demand was driven by the 'condo flippers,' that is people who were simply buying houses with the intention of selling them later at a profit. Now these people are stampeding to get out to save as much of their down payment as they can.
Goldman Sachs estimates home prices will fall by a further 15%. Shiller thinks it could be as high as 50%.This decline will have a wealth effect and people will reduce spending on other goods.Signs are visible in the fall in auto sales and even in manufacturing.This is worrisome because private consumption accounts for 72% of US GDP. The housing sector is only 5% of GDP and a slowdown there is not enough to trigger a recession but a slow down in consumer spending is dangerous.So to prevent a spillover of the housing crisis to the other sectors of the economy, which may cause the US economy to go into recession, the Fed will have to cut interest rates even at the cost of higher inflation. It is this certainty of a cut in interest rates which is behind the slump in the dollar.
The Fed also has to cut interest rates in order to protect the financial system. We neither know the exact extent of the losses on account of this sub prime mess nor who has lost money. Banks and other financial institutions have admitted significant losses but it is feared that they will report further losses in future. Other losers are the investors in the CDO's and other similar instruments.It is speculated that China and other West Asian nations flush with petro dollars had made large investments in such instruments. For an orderly winding down of these investments cuts in interest rates may be the only way out.
But in the end we all have to remember that the dollar can only fall this much and no more.Not only is the US the largest economy in the world , it also has the necessary policies and financial institutions in place which allows both the entry and exit of hundreds of billions of dollars that other nations wish to invest.So once this crisis plays out the and the US economy strengthens again the dollar is expected to regain its position as the most important currency in the world.
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