Why is the Dollar declining?

Daily Duck regular Michael Herdegen clued me into this article by Donald Luskin at SmartMoney.com:

SHOULD YOU BE WORRIED ABOUT the U.S. dollar? Should you be worried that it's trading at all-time lows vs. the euro, and at more than nine-year lows vs. a trade-weighted basket of foreign currencies?

Yes — you should be worried. The falling dollar is the one dark cloud on the market horizon right now, the one thing that has the power to threaten the post-election "Bush rally."

But the reason you should be worried about the dollar is very different from the scare stories you're hearing in the media. Let me explain. But to do so, I will
have to take the dangerous step of daring to disagree with a very popular and powerful market guru — Warren Buffett.

Buffett has announced to shareholders of his company Berkshire Hathaway (BRK.B) that he has taken a short position in the U.S. dollar. I'm not sure exactly how he implemented that trade, but at the moment, it's almost certainly in profit. That's great — my hat is off to him. The problem is, Buffett is making money on this trade by sheer luck, because his reasons for putting it on in the first place make no sense at all.

To oversimplify Buffett's reasoning a bit, he has shorted the dollar because he is worried about the impact of the U.S. trade deficit, which is now running at record levels in excess of $166 billion at a quarterly rate, as of the second quarter. As he wrote in an article for Fortune magazine, "our trade deficit has greatly worsened, to the point that our country's 'net worth,' so to speak, is now being transferred abroad at an alarming rate."

Luskin points out the real culprit:

Longtime readers of this column will know the answer to that. It all comes down to another financial guru who is just as dangerous to contradict as Warren Buffett — Fed chairman Alan Greenspan. Greenspan, like Buffett, is making a mistake about the dollar, and Greenspan's mistake is what's making the dollar fall. Greenspan's mistake is that he has kept interest rates too low for too long, and now inflation is beginning to creep back into the U.S. economy.

At last week's Fed meeting, Greenspan and his colleagues stated, "Inflation and longer-term inflation expectations remain well contained." They may be right about "expectations," but the reality of inflation is anything but "contained." Already this year, the "core" consumer price index, which excludes food and energy, has nearly doubled.

And don't let yourself think that the high price you are now paying for gasoline doesn't reflect inflation — it does. Measured in U.S. dollars, oil prices are near all-time highs. But measured in euros, oil prices are no higher today than they were three years ago. That's because the Fed has let the dollar weaken (so it buys less oil), while the European Central Bank has kept the euro strong (so it buys just as much oil as it used to).

And that's why the dollar is falling. It buys less than it used to — while the euro buys just as much. Therefore, by simple arithmetic, the dollar buys fewer euros than it used to. The falling dollar is a bad thing — but not because it means we are living in Squanderville. It's a bad thing because it means we are living in Inflationville.

So who do you believe? If neither Buffet or Luskin sund convincing, there are other theories. Larry Kudlow, on his weblog, argues that it is the fault of the Europeans (scroll down to the post titled "Money" from 11.10.04):

The Fed is right to follow market interest rates, especially its unregulated T-bill cousin. Would that the central market would decontrol its own overnight target rate; then market forces would run monetary policy rather than econometric models that abide by discredited trade-offs between inflation and unemployment. Also in the realm of market forces, the dollar lately has lost some additional value in terms of gold and foreign currencies. So there could be a small amount of excess money which needs to be absorbed by the government bank. When they raise their target to 2.25 percent next month it is quite possible that they will have removed the monetary excess. One important issue not mentioned in the Fed’s policy statement was the dollar. Everybody on Wall Street is talking about the falling dollar. They are obsessing about it. And most blame the lower greenback exchange rate on America’s widening trade gap. This is totally wrong. The main reason the dollar has slipped when measured against the euro is that European monetary policy and their creation of new euros is way too stingy; it is in fact still deflationary.
...
As for the trade deficit, the U.S. grows faster than its biggest customers. So we import more than we export. However, exports are rising at a 13 percent pace; a great sign of economic health. Imports are rising even more by 17 percent. We are selling goods and services to China at a 37 percent rate. But the volumes are too small to dent the trade gap. This will change over the next decade. Meanwhile, America’s profitable investment margins attract foreign private capital inflows from all around the world. Lately foreign inflows have come in around $600 billion, about the same as our $570 billion current account deficit for goods and services. In other words, there is no financing problem at all and no reason to tie the dollar to the trade accounts.However, it would be foolish if the U.S. Fed started targeting the euro for its monetary policy. If the Europeans are stupid enough to crash their economy, that’s their business. But whatever hedge fund traders may say, the U.S. must not make the same monetary mistake that would wreck our prosperous recovery. Domestic price stability should be the Fed’s strategic goal. As long as they follow interest rates and commodity movements, as Greenspan seems to be doing, then the U.S. will continue along a path of non-inflationary economic growth.

So you have 3 arguable "experts" on the economy giving 3 different explanations for the falling dollar. How does the average citizen, who is not an expert, decide who is right?

One of the challenges that I undertook with this blog is the question of how the average citizen, who is not an expert on such topics, should make decisions based on the multiple and contradictory positions taken by the "experts" in that field. We are all faced with that challenge, whether in economics, foreign & social policy, or science & technology.

One way to evaluate the experts is to look at their track records. From the trio cited above, Warren Buffett has by far the longest and most impressive track record. Buffett has been managing Berkshire Hathaway, a small insurance company turned investment portfolio, since 1965. He has turned many ordinary investors in his company into multi-millionaires, and his investments have far oustripped the major market indices through good times and bad.

Another way, and perhaps the best, is to reduce the topic to a question of basic principles. Economics, for all the mathematical complexity that is invested in some of its more advanced theories, is at its heart a simple set of relationships. When you hear justifications for policy based on a statement that deficits don't matter, a statement that contradicts a basic foundational principle of economic truth that any homeowner trying to balance her monthly household budget knows, then you know that you are being asked to look through the wool.

Deficits do matter, and that is why the dollar is heading south. For more deficit discussion, Matthew Yglesias has a good roundup from the blogosphere.