Can the U.S. Dollar Become Almighty Once Again?

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Financial turmoil in Cyprus, where the parliament rejected a plan an eurozone bailout deal that would have taxed bank deposits, is prompting investors to shift cash from the euro zone to the U.S. That’s boosting the value of the dollar — and it’s just the latest installment in a story that has helped the dollar strengthen for more than a year.

Despite gridlock in Washington and a string of economic mishaps, the dollar has risen by 7% since late 2011. That’s a striking turnaround for a currency that was in relentless decline for decades. If the upward trend continues – and there are good reasons to think it will – then the U.S. dollar could become almighty once again.

The dollar’s decline over the past 30 years has been far greater than most Americans realize. It has lost almost half its value against other major currencies since 1985 and is down 33% in the past 11 years alone. Indeed, the value of the U.S. dollar is lower today than it was in 2009 when the recession ended. In part, this fall occurred because of government policies in Europe and Japan that kept the euro and the yen overvalued.

A weak currency can bolster a country’s economy in the short run, by making goods cheaper for foreign buyers and thereby encouraging exports. But over the longer term, a robust economy is typically accompanied by a strong currency. A currency rises in value when more foreign money is flowing in than is flowing out. These inflows occur not only because of export sales but also because foreigners see investment opportunities or are seeking safe places to park their cash. As a result, a stronger dollar is a bellwether of an improving economy and a brighter outlook for U.S. stocks. And there are three reasons economists think the dollar’s rise could continue:

Other major countries are worse off economically. The U.S. economy may be sluggish, but it has grown for 14 straight quarters since the recession ended in mid-2009. By contrast, the Eurozone economies shrank last year and are expected to contract further this year. Moreover, two of the most troubled countries are Italy, which just had an indecisive election, and Cyprus, where yesterday the parliament rejected a plan to levy a one-time tax of up to 10% on bank deposits to raise money for a bailout. The U.K. is on the verge of its third recession since 2008. And China is retrenching because it fears a potential financial crisis. By comparison the U.S. economic outlook appears rather tranquil.

Other major currencies are still overvalued. One way to assess currencies is to compare how much they can buy in their own countries (known as purchasing power parity). By this measure, the euro, the yen, and the British pound are still overvalued by anywhere from 2% to 10%. Other currencies, such as the Australian dollar, Canadian dollar, and Swiss franc are even more overvalued. The only important exception to this pattern is China, which has long held down the value of its currency to encourage exports. The likelihood is that some of the overvalued currencies will depreciate in the coming months, thereby increasing the relative value of the U.S. dollar. If that does happen, the U.S. will not only remain an economic safe haven attracting investors who want to escape economic turmoil, but also an attractive place to invest for those who want to move out of declining currencies.

The U.S. dollar could become a sort of petrocurrency. Russia, as well as much of the Middle East, has long been sustained by the value of their energy exports. Now the current energy boom in the U.S. could help boost the dollar in two important ways. First, petroleum imports have turned down for the first time since the early 1980s. U.S. imports of foreign oil have fallen 40% over the past seven years, according to the International Institute for Strategic Studies, which predicts that the U.S. could achieve self-sufficiency in petroleum within the next two decades. That helps our balance of trade. And second, to the extent that overall energy costs rise more slowly, most sectors of the economy will enjoy slightly lower inflation pressures and slightly higher growth. That in turn will improve profits and support the economic recovery.

The quiet turnaround in the dollar helps explain why GDP has continued to grow and why the stock market has kept rising despite tax increases and spending cuts that are eating into the living standards of many Americans. There’s no guarantee, of course, that this trend will continue. But for the time being, all of America’s trading partners appear to be pursuing policies that will weaken their currencies. Japan’s new central bank chief, in fact, has called explicitly for devaluing the yen to stimulate the Japanese economy.

Quantitative easing in the U.S. – and the increase in the money supply that it produces – could still undermine the value of the dollar over the long term. So could runaway spending. The best policies for America now would concentrate on reining in entitlements rather than trying to reduce the short-term deficit further, either with tax increases or spending cuts beyond what’s already scheduled. It also makes sense to encourage the domestic energy boom, which will not only improve America’s security but also give both the economy and the dollar a little extra lift – perhaps for decades to come.

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