Falling Dollar

For the past decade, the US Dollar has been weak, falling against a basket of currencies. A falling dollar has many implications for both the US and world economy. It is not necessarily a bad thing. A falling dollar, in many ways, is necessary to readjust the global and US economy.

Reasons for Falling Dollar

Persistent US Current account deficit.

Due to a decline in competitiveness and a low domestic saving ratio, the US has been running a current account deficit. Basically, they are buying more imports of goods and services than they export. A current account deficit puts downward pressure on the dollar, especially as capital flows to finance the deficit dry up. Even after a recession and a rise in domestic spending, the US current account deficit remains persistently high (at $500bn). Some economists say a current account deficit is nothing to worry about and reflects the US ability to attract capital. But, there are signs that overseas investors are becoming less willing to buy US assets.

Long Term Changes in Structure of Global Economy.

In the post war period, the US economy was the world's largest and dominant economy. This meant the US dollar was the global reserve currency and used to denominate oil and gold prices. With the rise of China and India, and the Euro, the US economy is becoming relatively smaller. Thus, it is slowly and gradually losing its status as the world's reserve currency, which is pushing down the dollar.

Worries over Debt and Inflation.

The US is certainly not alone in having a rise in public sector debt. However, the recession and financial bailout is pushing US public sector debt towards 100% of GDP. Since the Federal Reserve is also pursuing quantitative easing (creation of dollar) investors are becoming more nervous about dollar assets. They fear, a prolonged policy of increasing money supply could lead to inflation and devalue the dollar.

Low Interest Rates

Low interest rates make it less attractive to save in the US; this should lead to lower demand for dollars and weaken currency. However, because many other countries (such as Eurozone) are experiencing volatility, investors are willing to buy dollar assets, even though interest rates are quite low

Related

• Understanding exchange rates
  
• Effects of Falling dollar
• Benefits and costs of a falling dollar
• The demise of the dollar
• Why is dollar falling?
  

Tobin Tax

Definition of Tobin Tax

• A Tobin tax is the name given to a specific tax placed on currency transactions.
• It was proposed by economist, James Tobin, as a way of stabilising currency markets.
• The idea is that by increasing the marginal cost of currency transactions it reduces the incentive to speculate on currency movements. In theory, this prevents destabilising swings in currencies.
• Tobin initially proposed a tax of 1% on all currency trades. This has subsequently been reduced to lower figures such as 0.25%. One UK proposal suggested a Tobin tax as low as 0.01%

Advantages of a Tobin Tax

1. By placing a tax on currency trades, it makes currency trading slightly less attractive. By marginally increasing the cost of currency trading there should be a reduction in speculative trading, leading to greater exchange rate stability in floating exchange rate systems.
2. Raises Revenue. The global trade in currencies has grown at a very rapid rate. In 2007, the global currency market was worth $3,200 billion a day in 2007, or £400,000 billion per annum. Of this, trade in Pound Sterling as £34,000 bn a year.
3. A tax set at 0.01% on just Sterling trades would raise £2bn a year. A tax on global currency trades could raise significant sums.
   
4. Redistribution from Financial Sector to Developing World. The idea of a Tobin Tax is often seen as a good way to redistribute income from developed world to the developing world. The idea has been seized upon by many aid charities and anti-globalisation protesters. Though James Tobin has often stated that the main purpose of the tax is not about raising revenue and redistributing wealth, but its impact on reducing speculation.
5. After damage created by speculative investments such as derivatives and futures trading. There has been greater support for intervention to reduce speculative buying in financial markets.

The famous investor George Soros has stated, though it would harm him personally, he thinks a variation of the Tobin Tax could be beneficial for the world economy.

Arguments Against Tobin Tax

• Difficult to tax all transactions, it may encourage investors to find ways around the tax.
• Decline in currency flows may harm functioning of markets and lead to poor liquidity in currency markets.
• Tax may be insufficient to prevent speculative flows and currency movements which are driven by economic fundamentals.
• A tax may discourage 'hedging' which is a way of insuring against currency movements rather than discouraging speculation.
  
• If it was introduced unilaterally in one country, e.g. UK then it would lead to loss of financial business as firms trade in other currencies / countries
• There may be better ways to deal with speculation e.g. placing lump sum insurance schemes on financial firms who invest in speculative markets.

At the G20 Support finance ministers in US and Canada were quick to condemn the tax, proposed by Gordon Brown, on the grounds of 'we are not in business of raising taxes'. But, the arguments against a Tobin tax are weak. Why do we happily accept a VAT Rate of 15% on basic goods yet, feel a tax of 0.01% on currency would be damaging and unfair?

A Tobin tax is more than just a measure to tax 'undeserving financial speculators' It is not going to undermine the world economy as some of the more extravagant claims may suggest. On balance, it is a sensible policy with many benefits - both economic and social.

Problems Facing UK Economy in 2010

It's been a bad 12 months for the UK economy. 2010, should see some kind of economic recovery. But, few are expecting a rapid rebound. These are some of the problems facing the UK economy, into 2010.

Depth of the Recession.

Typically, the UK economy expands at an average underlying trend rate of about 2.5%. Even zero growth will lead to a growth in spare capacity and unemployment. After 6 consecutive quarters of falling GDP, the output gap is significant. This means output is significantly below potential, firms will be reluctant to hire. There is a danger that the recession will lead to a permanent loss of output and jobs and shrink the UK's productive capacity .

Unemployment.

The Bank has an inflation target of 2%, but it is unemployment which creates the most social / personal misery. So far, the rise in unemployment has been relatively muted, at least, given the scale of recession. However, this slow rise in unemployment means it will be slower to fall. After the 1992 recession, unemployment fell relatively quickly, but after this recession, the fall in unemployment is likely to be slower - more like the experience of the 1980s where unemployment remained close to 3 million for several years. In particular, it is young workers who have been hardest hit. The fear is that prolonged youth unemployment could lead to a return to the unemployment related social unrest, characteristic of the early 1980s.

Budget Deficit.

In the past few years, the UK's public finances have taken a real battering, leading to record peace time deficits. We relied on bubble taxes (property taxes, income tax on bonuses e.t.c) to help fuel inflation beating rises in government spending. Yet, these tax sources have dried up leading to a budget deficit approaching £200bn.

The dilemma is that, although the budget deficit continues to rise towards 100% of GDP, reducing the deficit too early could push the economy back into recession. For example, if the Conservatives were to implement their plans for spending cuts next year, the deflationary effect could well push a fragile economy back into recession.

Problems of Prolonged Borrowing

Economic necessity will make it difficult to tackle the budget deficit. But, this means the budget deficit will continue to grow and this brings future problems. If debt grows too quickly towards 100% of GDP, it may effect the UK's credit rating. This would make it more expensive to borrow and pay the debt interest payments.

In the longer term, there is a also a fear relating to the size of the debt and quantitative easing. Increasing the money supply, rises the prospect of future inflation and a weaker sterling. At the moment, there is little real fear of inflation and a weak pound is helping the economy to recover. But, there is a danger continued high levels of borrowing could weaken pound and could create future inflation.

Trade Deficit / Unbalanced Economy

The UK has been running a current account deficit, more or less since the recession of 1981. The economy has relied on services and the financial sector. We have struggled to remain competitive in the manufacturing / industrial sector leading to a trade deficit. Often the problems of trade deficits / decline in manufacturing are exaggerated, but the UK economy does still feel unbalanced and this is one reason why the UK economy was hit by the recession much more than other countries.

Propensity to Boom and Bust

I have written about the problems of UK housing market in more detail here. Yet, the continued shortage of supply means the UK will be sensitive to future booms and busts. It is hard to believe house prices have risen so much in the middle of a recession - a sign of the fundamental imbalances which exist in the housing market.

Weak Sterling

At the moment, I don't see the weak sterling as an economic problem. The depreciation has helped to limit the fall in economic growth and, over time, will help to rebalance the economy and reduce trade deficit. But, if sterling continues to be weak over the longer term, there could be inflationary risks and a decline in living standards as imports become more expensive.

Demographic Changes - An ageing population and unfunded pension deficits, will make the governments public finances more difficult in the future.

These problems, could equally be applied to the US economy. I think one important issue is to be clear on which problem is the most serious. For example, government borrowing is a definite problem. But, although it is very serious, it is more important to worry about the loss of output and unemployment first.

Related

• Problems of credit crunch
• Problems of Recessions