If Foreigners Drop the Dollar — Watch Out!

[Hemidakota]

By David Frazier

As many of you know, I’ve regularly commented on ongoing economic developments in the U.S. since I began writing for MoneyNews.com last June.

However, I’ve rarely discussed economic or geopolitical developments in other countries. Starting today, however, I plan to occasionally write about important factors and events in various other regions of the world, especially those that I expect to affect security prices.

The reason that I have generally focused on the U.S. is because economic developments abroad have tended to respond to, and been largely dependent on, developments in the U.S. since the end of World War II.

Economic slowdowns (and expansions) in the U.S. have therefore historically led to economic contractions (or growth) in Europe, Japan and various other regions of the globe.

Contrary to the claims being made by some investment pundits, my research indicates that this time will be no different — that the ongoing economic slump in the U.S. will lead to slower growth abroad during the months ahead.

Economists at The International Monetary Fund (IMF) apparently agree with my prognosis, as the IMF recently lowered its 2008 forecast for global growth and said that there's a 25 percent chance of a global recession this year.

One of the more significant factors that I expect will impact foreign economies through the remainder of 2008 is the ongoing descent of the U.S. dollar. Over the past two years, the dollar has declined 24 percent against the Euro, 15 percent against the Japanese Yen, and 17 percent against a broad basket of other world currencies.

As a result of the continuing decline in the dollar, several Middle Eastern oil-producing countries decided over the past six months to un-peg their currencies to the dollar. If the dollar continues to fall, I would expect an increasing number of countries around the globe to de-peg their currencies to the dollar, too.

Why? Because the falling value of the dollar is adding to inflationary pressures in those countries that peg their currencies to the dollar.

The decision, if it were to occur and if a large number of countries de-peg their currencies to the dollar, could have enormous negative economic repercussions for the United States.

For example, there’s a good chance that both short- and long-term interest rates in the U.S. would rise sharply if a large number of foreign countries de-peg to the dollar because the U.S. Treasury would likely need to significantly raise the yields on its securities to persuade foreign investors to continue investing in them.

The falling value of the dollar also is causing political tensions between the U.S., France and other European nations. That’s because of the negative impact that the falling dollar is having on those foreign countries’ exports to the United States. The falling dollar makes European goods more expensive to U.S. consumers, thereby reducing American appetite for European goods.

Europe’s declining exports to the U.S. are, in turn, negatively impacting economic growth in many European countries.

For example, economic growth in Germany slowed to a year-over-year rate of only 1.8 percent during the fourth quarter of 2007, from 2.5 percent during the prior quarter and from 3.9 percent for the three months ended Dec. 31, 2006.

Growth also has slowed in France and Italy. On average, economic growth slowed in the 15 European nations that use the Euro to 3 percent during the first quarter of this year, from 3.3 percent during the fourth quarter of 2007.

The European Central Bank’s (EC ongoing efforts to fight inflationary pressures by holding its key overnight lending rate steady at 4 percent since June 2007, in conjunction with the Federal Reserve’s emphasis on trying to stimulate the U.S. economy by continuing to lower short-term interest rates here, will likely cause the dollar to continue to fall and for growth in Europe to slow even further.

Yet ECB President Jean-Claude Trichet seems intent upon continuing to fight inflation, and for good reason — consumer prices in the Euro region rose during March at the fastest pace since 1992.

In fact, the rate of inflation in the 15-country Euro region has risen by at least 3 percent during each of the past five months, well above the ECB’s official 2 percent comfort level. Last week Trichet said, “price stability is something which is essential for the poorest and the most vulnerable of our citizens.”

In light of the developments mentioned above, you shouldn’t be surprised if the value of the U.S. dollar continues to fall against most other world currencies and that inflation rates continue to rise. Such a development would, of course, bode well for those of you who are invested in commodities such as gold, silver and oil.