Trying to feel the pulse of the financial markets is a practical ambition. There are many indicators out there that can help predict nascent trends. In the macro global world, economists often use the relative value of the greenback to make a prognosis on the health of the U.S. economy. The health of the economy has a direct impact on the financial markets. Theoretically, the relative value of the dollar should be important to stockbrokers as well. In practice it is not; nevertheless, when the dollar swings swiftly in either direction, economists cry foul.

Recent predictions have used the falling dollar as a sign of a falling economy. Some even argue that it is a sign of a falling empire. Widely read papers abound with dark prophecies heralding the change of the world reserve currency from U.S. dollars to euros. Forecasts by some economists show dire consequences to the U.S. economy if the world, and China especially, were to stop purchasing bonds from the government. Surely, these events would have a grave impact on the financial markets.

Murder by suicide

There has been speculation that the falling dollar is not only welcome in the United States, but is actually a deliberate act of the federal government to lower the trade deficit. Assuming this were true, the momentum of the shift could cause the slide to continue past the point where the catastrophic financial predictions may come to pass. But this is all assuming we are operating in a vacuum. The idea that any of our major trading partners would wish to cause financial distress in the United States is a little hard to believe. All of the major economies rely on us and each other to maintain stability and growth. If the global economy were a human body, China could be the kidneys, Europe the liver, Japan the lungs, Canada and Mexico might share the spleen. OPEC could be the pancreas, but the heart and brain would still be the United States (California on its own could be a ventricle). In a highly interdependent world, economic distress in a part as important as the United States is bound to cause equal distress in other parts of the world. Thus, they buy our bonds and we buy their goods. They have to trust that we will eventually repay our debts. It might sound naive, but it could be that simple. Of all the major economies, the United States is also the most robust and the one with the best demographic prospects. Investing in the United States is something of a layaway plan for economies that are growing less quickly and/or growing older more rapidly. How much do other countries care about the health of the U.S.? Recent history tells us that they care very much.

Enter the G7

The year was 1985. The place was The Plaza hotel in New York. Government officials from the United States, Germany, Japan, Britain and France were looking for ways to lower U.S. dollar value and narrow the trade gap. Agreements reached at what would be called The Plaza Accord successfully caused the dollar to lose 30 percent of its value. The following year, the Fantastic Five invited Canada and Italy to the party. The Super Seven, or G7, continues in its effort to tame the world economy.

The other side of the coin

Roman aureus, English pound sterling, U.S. dollars, and the euro? Reserve currencies ultimately change and these changes often correlate with the rapid decline or fall of a great empire. There have been many large national economies built throughout history, but the world currencies are always minted by the great military powers. The United States seems to have locked up the position of world military superpower pretty handily, but armies don’t pay for themselves (except maybe in China). If the United States overextends its abilities, there can most definitely be a reckoning. Mismanagement of funds can plague countries just as badly as it plagues companies. Perhaps the European Union does offer a more stable currency. As a conglomeration of nations it is more difficult for a sudden policy shift in any one country to drastically affect the valuation of the currency. However, for any other country’s debt to become a world reserve currency in the way that U.S. government securities have become, there would have to be physical security backing that currency, and Europe lacks the military might to offer that kind of assurance.

It’s like déjŕ vu all over again

The global economy is in deep trouble, mainly because of U.S. excesses: excessive budget deficits, excessive trade deficits, excessive inattentiveness to domestic social ills, and excessive reliance on military strength. “American policy in recent years,” we were told, had been “more and more addicted to wishful thinking. Economically . . . the era of comfortable self-indulgence appears near its close. Today the United States is on a collision course with history. The American fiscal dilemma must be resolved, and the perpetual instability of the dollar that is the consequence must cease.” [David. P. Calleo, Harold van B. Cleveland and Leonard Silk, “The Dollar and the Defense of the West,” Foreign Affairs, vol. 66, no. 4 (Spring 1988): 860-61.]

Yale historian Paul Kennedy argued is his book, The Rise and Fall of Great Powers (Random House, 1987) that America of the mid- to late ´80s was following a historic road to economic decline. He explained how many nations which had risen to the status of world powers, measured by economic and military might, overextended themselves and eventually fell into a relative economic decline. Further, he wrote that relative economic standing among nations was important only because it largely determined relative political and military might in the world. His arguments were based on the circumstances of those times.

The late 1980s witnessed one of the steepest declines in the dollar’s value since we got off the gold standard. This was of great concern to many economists and politicians, and spawned many articles and books. Their arguments hinged on the concept that the value of the dollar would continue to fall and that the fall would reinforce poor expectations of U.S. economic growth and would spur inflation as the prices of imports rose. As it turned out, their arguments, though well thought out, were just plain wrong. Contrary to what they predicted, the 1990s did not experience a steady decline in our economy and the standard of living rose markedly. Inflation was not a major factor in the 1990s.

Be aware

Ten years from now an economist will blurt out that they were right. At the same time someone else will forecast dire consequences for a current trend. Foretelling the future is a fool’s game, but staying on top of things is wise. While the future of the United States may remain as bright as ever as its currency fluctuates, the outlook for specific investments will change dramatically. What’s neutral for the United States might be good for GM ... or it might not. Take a look at the dollar every now and then. At the very least, you can claim that you were paying attention.