Diving Dollar Is a Vote of No Confidence

Here's the deal with the falling dollar: Over the long run, a country's currency reflects its economic strength. When the U.S. economy boomed in the '80s and '90s, so did the greenback. So when the greenback is tumbling, I prefer to go beyond short-term factors such as whether the Federal Reserve is cutting interest rates or what the near-term inflation outlook is. Perhaps the deep factor at play here is a global vote of no confidence in the direction of American economic policy. First, you have a Congress that is tilting protectionist. As Morgan Stanley's Stephen Roach writes in a New York Times column this week:

The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour. New legislation is likely that would impose trade sanctions on China unless it makes a major adjustment in its currency. Not only would this be an egregious policy blunder—attempting to fix a multilateral deficit with more than 40 nations by forcing an exchange rate adjustment with one country—but it would also amount to Washington taxing one of America's major foreign lenders. That would undoubtedly reduce China's desire for United States assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure.

Then there are taxes. The recent budget proposal pushed by Dems on Capitol Hill would raises taxes by $900 billion over five years and a projected $3.3 trillion over 10 years, with a good chunk of that increase coming from letting the 2001 and 2003 Bush tax cuts expire. And it's not just Congress. Presidential candidate Barack Obama has proposed lifting the earnings cap on Social Security taxes, a move that, as Harvard economics professor Greg Mankiw notes, could have the effect of raising the top marginal tax rate from 35 percent to 47 percent. Maybe the best thing going for the dollar is that its major competitor, the euro, is backed by countries with even bigger long-term problems—primarily an aging and eventually shrinking population that can't support a big welfare state—than the United States has. China and the nations of the Organization of Petroleum Exporting Countries may well be diversifying their currency holdings and buying euros, but we're a long way from the dollar losing its top status.