The Case of the Shrinking Dollar

What is the dollar really worth these days?

It depends on who you ask. But everyone seems to agree it is worth far less than it once was.

One reason it’s hard to find a definitive answer is that the value of the U.S. dollar is tied to a variety of dynamic factors including interest rates, government spending, inflation, economic growth, balance of trade, and investor confidence.

What we do know is that, from a long term perspective, the dollar has lost value. In part this decline can be attributed to the growing U.S. debt which is now over $13 trillion. This growing deficit has encouraged some foreign investors, including central banks, to diversify their portfolios with non-dollar assets to reduce the impact of a falling dollar on their investments. The higher our national debt, the more likely the value of the dollar will fall. And, as interest rates continue to hover at record low levels, so do the returns on Treasury bonds priced in U.S. dollars. Further, the government continues to fund the debt by auctioning off more U.S. Treasury notes.

At a time when the U.S. runs a $40 billion trade deficit, a falling dollar cuts into Americans’ buying power in the global marketplace, and could ultimately lead to higher inflation. While a weak dollar can benefit American exporters by boosting economic growth, it can also help the Federal Reserve guard against deflation.

When measured by its exchange rate compared to international currencies, the dollar’s value is even more of a moving target. The dollar rises and falls against the euro based on factors like the overall strength or weakness of the economies of the United States and European Union. It currently has a low valuation against the Japanese yen and continued to slip recently on disappointing U.S. economic data. After being overvalued against the Chinese yuan last fall, the dollar lost ground recently as the yuan rose to a one month high. It may decline further as foreign governments concerned about holding excess reserves in devaluing dollars move away from the dollar into alternate currencies or commodities such as gold.

Virtually all countries hold foreign currency reserves of some sort. When large countries like China, Japan and other international trading partners export more than they import, those governments hold some of their excess cash in foreign currency reserves, commodities, and other equity investments. However, amid increasing concerns over long-term deficits, these countries reduce the percentage of their reserves held in dollars. This move by other countries into alternate currencies or commodities further weakens the value of the dollar. Indeed, from Q3 2008 to Q4 2009, total measurable foreign government reserves in dollar based assets decreased from 67% to 62%.

Countries holding excess dollars in many cases lend them back to the U.S. by purchasing Treasury debt worth billions of dollars. Because our government is either unwilling or unable to balance our budget by raising taxes or significantly cutting spending, we continue to churn out yet more Treasury debt and further erode the value of the dollar.

These factors that all contribute to the declining value of the dollar can influence foreign investors to reevaluate their dollar denominated investments. As evidenced by major acquisitions of gold by countries like China and India, the global market has been seeking ways to diversify dollar risk. Individual investors should consider the benefits of diversifying their own portfolios including the addition of gold.

In times of economic uncertainty, gold can offer important diversification. Over the last decade, gold prices have risen more than 300% in value, and continue to surpass previous record highs. While gold has been in a long-term uptrend since 2000 it is still trading well below the inflation adjusted 1980 high of $2,309 and respected analysts continue to see room for further gains.

Editor’s Note: Investing in gold or precious metals is easy. If you have questions click here for more information.