Readers Question: I have been interested in the US economy in the last few months, and with current news of their $14 trillion debt problem heating up, I’m wondering could the demand for dollars go down, if they were possible to have a similar or close problems of debt issues like Greece, and if the demand goes down, does that mean the dollar goes to $2.00 to the pound… The whole idea of currency going up and down confuses me greatly… I would be gratefully appreciative if you could explain this notion to me.
It is quite possible that fears over the size of the US debt could cause a fall in demand for dollars. If demand for holding dollars fell, it’s value would fall (e.g. the dollar goes down from and the exchange rate of $1.5 to a pound to $2 to a pound).
If people felt the US was borrowing too much, there is a risk the US could default. This means that people who hold US government bonds would lose their money (or part of their money). Therefore this prospect of losing the value of US securities means people may not want to hold US bonds. Instead, they may think the UK is a safer place to save money. In this situation, people would sell US bonds and buy UK bonds instead.
Therefore, there will be an increase in the supply of dollars and higher demand for Sterling.
Therefore, as you suggest the value of the dollar is likely to fall and the value of sterling likely to rise.
It is like the price of a cup final ticket. If everyone wanted to buy the ticket, the price would go up. If everyone wanted to buy Pound Sterling (because they felt it was the best currency), it’s value would also increase.
Will the Dollar Actually fall?
Although the US debt of $1.4 trillion sounds an awful lot, it may be that investors still feel the US dollar provides a relatively attractive option. The US economy often proves resilient and long term economic recovery would help to reduce its debt to GDP ratio.
Also, although US debt has increased, people at the moment still seem willing to buy US bonds (interest rates are quite low). This suggests the markets still have confidence the US will honour its debt and meet its requirements.
The US is quite different from the Greek situation. In Greece, they have more serious problems, such as they can’t devalue, can’t pursue quantitative easing and don’t have the same flexibility. Also, their economy is predicted to experience a prolonged period of recession / stagnant growth due to the spending cuts. Therefore, in this situation, the US debt situation seems more manageable and so investors may continue to hold dollars.
Also, it is worth bearing in mind, that many other major currencies have similar problems to the US. The UK debt situation is similar to US. Also, the Eurozone have many potential problems. Japan’s public sector debt is twice the size of the US. Therefore, relatively, the dollar is still seen as one of the best bets.
However, if something unexpectedly bad happened to the US economy. E.g. plunged back into a deep recession and borrowing rapidly increased, then this may lead to a big sell-off of dollars and its value would fall.