What's a Dollar Worth?

Understanding the dollar's place in the World

Phil Diamond, CFA | Oct. 19, 2009

The dollar, or any currency, has several major functions in an economy. The one we are most familiar with is that of a "medium of exchange." That means we go to the bar with a ten in our pocket and exchange that for a beer and a sandwich. We have exchanged money for goods. The second is what we call a "store of value." You can take that ten and put it in your pocket (or in your bank account) and leave it there and you've got purchasing power tomorrow. The third function of currency is as a "unit of account," which is what happens when, for example, we buy $1 billion worth of stock when what we really own are a bunch of electronic blips on a computer at Fidelity, but we account for everything in dollars. We use the currency to account for the real value of the goods. That is the only difference between a medium of exchange is that we use it whether we make an exchange or not. Money, to be any good, has to be "legal tender." That means we can use the money to pay our taxes, pay our bills, repay our loans and other legal obligations (see Shakespeare's The Merchant of Venice). Since it is legal tender, the other party has to take it even if is worth less than the dollars they lent us or whatever. 

All of these functions of money have gone on for quite a while now. The Romans looked at money much as we do today in every day usage, so did the Chinese and the Etruscans. Some of that applies in one sense or another when it comes to international exchange in currencies. Whether we are trading sterling for yen or Rubles for loonies, we are just exchanging one thing for another at a varying price, medium of exchange.

When we buy oil from Venezuela, they take dollars for the oil (medium of exchange, not legal tender). They then take those dollars and buy whatever they need from other folks (medium of exchange). The beauty of the dollar is that they can actually do that. The same thing doesn't work with Venezuelan bolívares fuertes or even Swiss francs, necessarily. There is no assurance that the other folks they are trading with will accept bolivars or francs. The dollar acts in international trade much like it does in everyday transactions here in America. No other currency works quite as well as that. So dollars are the world medium of exchange.

Many foreign central banks keep a lot of their surpluses in dollars (store of value). They don't have to, but they choose to for a variety of reasons. Most of these reasons date to the era right after World War II when about the only currency that was readily available internationally was the dollar. There were plenty of them and the world's leading central bankers decided at Bretton Woods to agree to accept dollars at a fixed exchange rate and that the dollar would be exchangeable into gold at a fixed price. So, dollars are the central banker's store of value.

We are not the world's unit of account or the world's legal tender, but two out of four is at least one more than any other currency has going for it. It is these two reasons why the dollar is an issue today.

So, is the dollar overpriced? Is the dollar underpriced? We don't know. We suspect that the dollar has been temporarily overpriced due to the huge dollar rally driven by the flight to safety trade during the financial collapse late last year and earlier this year (store of value). Much of the decline in the dollar from its highs is likely due to unwinding that safe haven trade (store of value). 

Imagine if you are a European businessman with some spare cash sitting around and then the bottom falls out of your economy, your market, and your bank. Wouldn't you like the idea of having some sliver of your assets in dollars, where, no matter what, you would be able to retrieve those dollars in the future? Yes, you would. That is one reason why the dollar rallied during the crisis. Now that the crisis is past, the benefit of having that safe haven has receded. So too has the price.

Will the dollar crash? Probably not, just because so many people have such a vested interest in the way things are. Will the dollar go lower? Probably. So, why do we say that it probably won't crash but it will go lower? Largely because the dollar is still the world's reserve currency, it is the medium of exchange and the store of value for many folks. That is a fact that most people can't get through their thick skulls, the dollar is special. That is also why having more central banks use currencies other than the dollar as their reserve currency is important. The day may come when the dollar isn't the medium of exchange and store of value it is today. On that day, the dollar becomes no better than the Brazilian real or the Saudi riyal or the Israeli shekel. When we have just another currency, all our bad habits of running huge trade deficits and fiscal deficits will become a lot more expensive and painful. We may have to straighten up, and quickly.

If the dollar does set out on a long period of slow erosion of value, then the day when we are no longer the world’s reserve currency will arrive a lot sooner than we might expect. This administration, like most administrations before it, will let the currency slip even though they will talk a lot about a strong currency. The idea is that a cheaper currency makes buying imports more expensive and makes our exports more attractive so, as the theory goes, we will narrow or eliminate our trade deficit. Good luck on that. It hasn't worked for the last forty years and it won't likely work now. The reason is oil. Oil is most of our trade deficit and we will keep buying it even with a depreciated currency. So, as long as most of our trade deficit is oil, this approach will not work.

Would we be better off with a strong dollar? We might be. If we can trade a few jobs for a stronger currency we will get the benefit of cheaper oil and hence lower trade deficits. We will also make a better store of value and medium of exchange for everybody else in the world. That would keep the dollar the world’s reserve currency. You don’t need euros if the dollar is as “good as gold” – then you wouldn’t need gold either.

We would like to thank our colleagues and business partners at FocusPoint Solutions for their contribution to our Commentary. Particular thanks go to Phil Diamond, CFA; Ryan Long, CFA and all within their research staff. We look forward to their on-going  Commentary contributions.

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