Don't Count Out the U.S. Dollar

What a difference 10 years makes.

The euro began trading in January 1999 and by September had lost more than 25% of its value. That month, then-Treasury Secretary Larry Summers met with European finance ministers in Prague and reaffirmed U.S. willingness to invest dollars in support of the floundering currency. Publicly, it was billed as help for old friends. Editorials at the time guessed that American policy makers secretly wouldn't mind if the dollar lost a touch of its strength, since that would make exports cheaper for European buyers.

If that was the plan, it has worked too well. A decade later, the Euro has gained more than 60% against the dollar, and it is America whose currency seems unstable. Yen, Canadian dollars, oil, gold—these assets and many others buy far more dollars today than a decade ago. Nobel economist Joseph Stiglitz, Chinese central bank governor Zhou Xiaochuan and Russian President Dmitry Medvedev have voiced support in recent months for a super-national currency to take over the dollar's role as a parking place for global reserves. In July, Medvedev even presented Group of Eight conference attendees in Italy with a minted coin mock-up bearing the words “United Future World Currency.”

To the wrong-way trading momentum and bashing from on high, add a worrisome budget deficit. The latest forecasts say the U.S. government will overspend its tax receipts this year by $1.6 trillion. Just five years ago, a figure one-quarter that size was cause for serious worry.

All told, now seems a lousy time to hold savings in dollars, especially while interest rates on savings accounts are pitiful. Don't be too quick to count out the buck, though. Fundamentals suggest it's due for a lift.

Consider something called purchasing power parity. Among countries with roughly equal standards of living, identical goods should cost about the same after adjusting for exchange rates, the theory goes. If a hamburger costs two American dollars but only one British pound, the two currencies are at equilibrium when a pound buys two dollars, so long as the two burgers are of similar quality. The Economist magazine uses just that — the local price of Big Mac hamburgers — to judge which currencies are more or less dear than they should be. At its last reading, the Big Mac index said the euro was nearly 30% overvalued. The Swiss franc was the costliest currency. The British pound, down sharply against the dollar over the past two years, seems nearly cheap enough. Most Asian currencies look underpriced.

Of course, the Big Mac approach is only a half-serious one. While the burger might be a fine good for such analysis, given its global reach and eerily consistent quality, a basket of many goods gives a more reliable read. The Organization for Economic Cooperation and Development tracks just such a basket. Its figures, too, say that life in the euro zone (but not Eastern Europe) is too costly to justify present exchange rates. Commodity-rich countries like Australia seem to have overpriced currencies, too. Asia again looks cheap.

If America is unable to close its gaping budget deficits in coming years, the dollar might indeed tumble. But don't expect it to do so relative to the currencies of peer nations. Japan owes far more relative to the size of its economy. France and Germany, almost as much. The U.K. owes less but its debt is growing fast. And the U.S. is expected to have a much younger population than these countries in coming years—a key predictor of a nation's ability to generate economic growth and tax revenue.

The 1% that U.S. money markets pay savers at the moment won't make anyone rich. But the dollars stashed in them might be something of a bargain.