THE STRENGTH OF THE DOLLAR -- WHAT DOES IT MEAN?
By: J Scott
Anyone who follows economic news has probably noticed that there's a lot of talk over the past 6 months about how strong the US dollar has gotten. And while we as Americans probably assume that a strong dollar is only good for our economy and our country, the reality is that in addition to the upsides, there are also several downsides to our currency gaining strength.
Because this is counterintuitive, I thought I would take a few minutes and explain some of the benefits and drawbacks to a strong dollar. But, let’s start with the basics…
What Does a Strong Dollar Even Mean?
First, let's start with the question of, “What does it mean to have a strong dollar (or a strong currency, in general)?”
When we say the dollar is strong, what we are really saying is that the dollar is strong compared to other currencies. Currencies don't get stronger or weaker by themselves. A currency can only get stronger or weaker compared to other currencies.
If the dollar is stronger today than it was yesterday, that means that a dollar today can buy more of another currency than it could buy yesterday.
As an example, let's look at one of the biggest moves the dollar has made in the past year. A year ago, one US dollar could purchase about 110 Japanese Yen. Today, one US dollar can purchase nearly 145 Japanese Yen.
In other words, the US dollar has gotten about 30% stronger compared to the Japanese yen over the past year.
Why Does a Currency Strengthen?
The next logical question is what drives a currency's strength up or down?
To answer this question, it's important to remember that a currency isn't just used to buy and sell stuff. Many large investors, including trillion-dollar funds and even other governments, use currencies as an investment vehicle.
For example, when the US government needs to “create” more money, they do so by issuing treasury bonds. Bonds are just a debt instrument that the government sells to raise money. Whoever buys and holds a bond gets paid interest on a regular basis in return for holding some of the government's debt.
Most US bonds these days are paying somewhere between 1% and 3% annual interest. With hard assets around the world losing value, many large investors are perfectly happy receiving these relatively low returns because they know that investing in US government bonds is the safest investment on the planet.
The only way an investor loses money is if the United States defaults on its debt.
When investors start to move money out of one currency into another currency, currency losing the investment weekend and the currency gaining the investment strengthens. Over the past several months, the US has been raising interest rates, which has led to an increase in bond rates. Investors are getting a better return by investing in US bonds than they were 6 months ago.
For that reason, money from around the world is flowing out of other currencies and into US bonds. And all of this money flowing out of other currencies and into the US dollar is what has strengthened the US dollar compared to nearly all other currencies around the world.
Why Is a Strong Dollar Good?
Obviously, there are some upsides to having a strong currency. It means that investors and governments around the world have faith in your economy. A strong dollar reinforces the fact that the US is worth investing in and being a trading partner of.
More importantly, it gives us confidence that no other currency is close to replacing the US dollar as the world's reserve currency. Meaning that for the foreseeable future, the US will continue to be the dominant global economy.
But a strong dollar is also good for individual American citizens as well.
We can travel abroad for cheaper. Because our dollar can buy more of other currencies, we can travel and exchange US dollars for local currencies, get more of that currency, and be able to buy more stuff in the local currency.
Additionally, anything we import into the US is cheaper. The countries we trade with do business in their local currency, and when our currency is stronger than theirs, we can buy more of their stuff with less of our own currency.
Why is a Strong Dollar Bad?
But there are also some downsides of a strong dollar.
While it may be cheaper for US citizens to travel abroad, it's now more expensive for foreigners to travel to the US. Because much of our economy relies on tourism -- think Disney World, Las Vegas, New York City, etc. – having fewer overseas visitors will hurt local tourism economies and the broader economy as well.
A strong dollar is also bad for US companies that rely on exporting their products around the world. While it's cheaper to import when the dollar is strong, it's more expensive to export. Products are more expensive to foreigners purchasing in their local currency, so they buy less of those products and US companies suffer.
From a global standpoint, a strong US dollar often means that emerging economies will suffer. Smaller nations that are looking to enter the global marketplace (which is good for the global economy and international trade) we'll find it more difficult to gain footing because their currency gets weaker.
Money is moving out of their currency and into us dollars. Their exporters are making less money. Their imports cost more. Long story short, a strong US dollar is bad for emerging countries and global trade.
Next time you hear that that the US dollar is getting stronger, remember that while this is good in many ways, it also comes with downsides that can affect not only individual Americans, but also US companies as well as the global economy.