What if?

One of my great fears is that this current economic crisis will lead to a crash in the value of the US Dollar. This is something I have been predicting since at least 2005 and now seems more certain than ever.

Of course, what prompts me to write this is the recent drop in the US Dollar. Is this the beginning of the end? I honestly don't know. The thing about predicting economic trends the way I do is that the event occurring is more certain than when it occurs. The US Dollar may jump back up to last week's levels in the next 24 hours, but the downward trend is more likely to occur at some point than any time before. It's like geologists making predictions about earthquakes or volcanic eruptions - the signs are all there that it will happen, but the actual time and date is unknown. When it comes to the US Dollar crashing, the same principle is in effect.

So, assuming I am correct, what will happen to America after the Dollar crash?

1. Economic decline - even more.

It's hard to imagine, but the most obvious effect of a currency crash is economic decline. In normal circumstances this would be bad enough, but, if judicious economic and financial analysts are to be believed, America is already facing the worst economic conditions since the Great Depression. The subprime bubble has spread financial contagion all throughout the US. Big companies are going bankrupt, the sharemarket is volatile and unemployment is rising. And that is all happening before a dollar crash.

If and when the dollar crashes, the effects of the crash will reverberate throughout the economy. While the current credit crisis is hitting mainly financial firms while manufacturing and services take some serious collateral damage, a crash in the dollar will heighten these effects. Banks and financial firms that could have been saved from bankruptcy won't be saved. Firms that could've survived battered and bruised will go under. People who would've been able to keep their jobs throughout the original crisis will lose them. A dollar crash will take the damage already done and make it worse.

In terms of official statistics, you can already see GDP reclining. 2008 Q3 will most likely see economic decline when the stats get released in October. Unemployment, already at 6.1%, is likely to increase. But a dollar crash will make these worse. GDP will continue to decline for 2 or more quarters after the dollar crash, and unemployment will continue to rise.

As I have pointed out above, economists and financial analysts see this crisis as being the worst since the Great Depression. This means that unemployment is likely to reach, at the very least, the levels of the early 80s recession - 10.8% in November and December 1982. Now add to this the dollar crash and you can add a few more points to that level. Unemployment of 12% or more is likely.

2. Inflation and the policy problems that follow it.

The most obvious effect of a dollar crash will be a substantial increase in inflation. The United States is a consumer-based economy rather than a producer-based economy. This means that much of America's economic life depends upon the consumption of imported goods. If and when the dollar crashes, the price of all goods and services will increase.

A dollar crash will make imported goods more expensive to import. Americans will therefore find that everything from gasoline to teddy bears will begin to cost more.

Debate still rages over whether this crisis will lead to increased inflation or deflation. The "Deflationistas" - those who believe that prices will drop - argue that a credit crunch of the sort we are experiencing has historically led to deflation, that is, falling price levels. These people are actually correct in a sense, as any economic contraction leads to lower levels of demand for goods and services, which will inevitably lead to downward pressure on prices. Unfortunately, these deflationistas don't take into account something as serious as a crash in the dollar. If the value of the US dollar is ignored in calculations, then deflation is a natural conclusion for those who are studying the current credit crisis. The problem is, though, that recent history - namely the 1997 Asian Economic Crisis and the 1998 Russian economic crisis - shows that any credit crisis in economies with floating currencies (ie, currencies that are traded in the marketplace and change in value accordingly) eventually leads to capital flight - a situation in which people take assets and money out of an economy in order to invest it in another. What happened in 1997 and 1998 was that investors ran from Asia and Russia and invested in the US Dollar.

So, in the midst of the worst financial crisis in over seventy years, a dollar crash would inevitably lead to upward pressure on prices- namely, inflation. What these inflationary levels might become depends upon how far the currency crashes - the more the currency crashes, the higher inflation will get.

In the midst of this situation, what can the government do? Very little I'm afraid. The only government institution charged with the task of controlling inflation is the Federal Reserve Bank. Faced with a dollar crash and spiralling inflation, what would the Fed do? Standard monetary policy is for central banks to raise interest rates to control inflation. In the past, the Federal Reserve has indeed lifted rates whenever inflation began to worry them.

The problem with raising interest rates is that, while it ends up controlling inflation, it also acts to dampen economic activity. If the Federal Reserve should raise rates in response to inflation brought about by the dollar crash, the effect upon an already deteriorating economy would be devastating. Yet to keep rates low and to endure inflation in the hope that the economy might be given a chance to recover is a process which has historically never worked - the 1970s, for example, saw central banks all over the world ignore inflation and focus on employment and economic growth. Despite this, neither the economy nor levels of employment nor inflation were ever fixed. It was only until Paul Volcker bit the bullet and killed off inflation with high interest rates in the early 1980s that inflation, economic growth and employment ended up getting fixed. In other words, the only way for central banks to improve economic conditions and levels of employment is to focus solely upon inflation. In our particular situation, with a potential dollar crash looming, the only thing the Federal Reserve Bank could do in response is to raise rates.

I need to reiterate: There is nothing that the President, Congress or the Federal Reserve Bank can do to solve this problem. The only thing they can do is to limit the damage and remove the policies that caused the problem in the first place. As I have mentioned before, the only thing that the Government can do is:

• Cut military spending
• Raise taxes on the rich
• Run a budget surplus and pay off public debt
• Use interest rates to keep inflation low
• Regulate the financial industry with more common sense laws
• Fire Ben Bernanke
  

As I said, none of these things will solve the crisis, but they will give a better grounding for the eventual economic recovery.

I would also add to this list the following:

• Institute a Universal Health Care system, and raise taxes to pay for it.
  

I don't put this here just because I'm a pinko commie subversive, but because it also makes economic sense. The United States of America could cut its total health care costs by one third if it instituted a Universal Health Care system similar to those already in operation in other Western nations. The US spends around 15% of GDP on health care while comparable Western nations spend around 10% of GDP and have the same - if not better - health outcomes. Cutting health care costs by deprivatising and regulating the health industry will have enormous social and economic benefits.

3. A Current Account Surplus as America recovers.

Although I often joke that a dollar crash will be "financial armageddon", I know that things will eventually turn around. Even the great depression ended, although those who suffered through it thought it might never end. The same is true in this case. The current crisis added to a dollar crash will cause some very serious economic damage, but a recovery will naturally follow (although the speed of this recovery might not be as fast as people hope).

One thing that will happen as America - and the world - recovers from an economic disaster and dollar crash is that the US will eventually become a net exporter. Moreover, the United States will eventually end up running a current account surplus. This will be the natural effect of a dollar crash.

If and when the US Dollar crashes, one result will be that American goods and services - even manufactured goods - will become more competitive on the world market. While the dollar crash will naturally hurt every part of the economy, international demand from US manufacturing will increase. America's economic recovery will be in many ways due to an increase in demand for American goods. Instead of being a consumer nation, the US will become a producer nation after the dollar crash.

Moreover, it is also likely that the world's producer nations - especially those who have run massive trade surpluses like Japan and China - will end up becoming consumer nations. This will be because the dollar crash will end up overturning current trade balances. It may seem strange to believe that Japanese consumers might end up buying US manufactured goods, but, if a dollar crash occurs then the natural corollary will be a rise in the value of the Yen and other world currencies. When a currency rises, imported goods become cheaper to buy and exported goods become more expensive to sell.

4. A New International Economic Order.

One eventual result of this crisis will be a new economic world order. I'm not talking conspiracy theories or a one world government here, I'm talking about a more integrated world economy in which trading nations agree to abide by treaties that will determine what sort of policies are implemented in national economies.

Such treaties already exist. Supranational entities like the United Nations, the World Bank, the International Monetary Fund and the World Trade Organisation all exist as a way of creating and developing international co-operation in economic areas. An even more advanced supranational entity - the European Union - has even greater power over how member countries may run their affairs.

For anyone who insists upon national sovereignty, such entities are despicable and evil. For those of us who know just how important common rules and policies are for international economic well-being, such entities are exceptionally important (although certainly not perfect).

The importance of any future economic agreement rests upon the damage done at present. Although the US is a sovereign nation and its economic downturn is entirely its own fault, the damage that it will create will spread around the globe. No nation linked in with the world economy will escape damage, although it is clear that the US will be the nation most badly affected. Given that this is the case - that one nation's economic stupidity can lead to economic pain for all nations - economic treaties and agreements will be put in place to ensure that all nations who participate in the world economy follow "the rules" to prevent their own contagion from affecting everyone else. One aspect of this agreement may be common monetary policy, whereby central banks will pursue the same goals, such as having common inflation targets. Another agreement may be universal rules applied to financial sectors, which would not only prevent economic problems in one nation, but in all nations who are part of the treaty. In America's case, accounting principles would be better suited following international rules rather than the homegrown American ones.

Conclusion

For some, a dollar crash will lead to financial armageddon. But, just like in the Great Depression, the United States and the rest of the world will recover and learn from the mistakes that were made. Unemployment may sky-rocket and the economy may decline, but they will both recover eventually.

Unfortunately I'm not as confident as I could be at this point. Peak Oil will make it very difficult for economies to recover over the next 10-20 years, while Global Warming won't stop just because humans have had some economic problems. Both of these issues will require much thought and changes in economic and social behaviour - changes which will cost but which are necessary if people's lives are to be saved. Moreover, the economic and social challenges posed by both Peak Oil and Global Warming need a workable economy to be faced.