Watch the Dollar

"If housing prices fall back in line with the overall rate price level... it will eliminate more than $2 trillion in paper wealth and considerably worsen the recession. The collapse of the housing bubble will also jeopardize the survival of Fannie Mae and Freddie Mac." -- Dean Baker, September 2002

The housing bubble was the first to burst, but it will not be the last in this global recession. These days, it’s the impending bust of the dollar bubble that should be getting more attention.

The U.S. dollar has been severely overvalued since the late 1990s, which has led to an enormous trade deficit that peaked at almost 6 percent of U.S. GDP in 2006 ($900 billion in today’s economy). This is unsustainable. Eventually, it will force the dollar to fall to a level where trade is close to balance.

That process was already gradually underway. The recent crisis, however, has sent investors scrambling to the dollar for safety, causing it to soar against most other currencies. The rising dollar, coupled with recessions in much of the rest of the world, will cause the trade deficit to rise again.

But once the financial situation begins to return to normal (which might not be in 2009), investors will be unhappy with the extremely low returns available from dollar assets. Their exodus will cause the dollar to resume the fall it began in 2002, but this time, its decline might be far more rapid. Other countries, most notably China, will be much less dependent on the U.S. market for their exports and will have less interest in propping up the dollar.

For Americans, the effect of a sharp decline in the dollar will be considerably higher import prices and a reduced standard of living. If the U.S. Federal Reserve becomes concerned about the inflation resulting from higher import prices, it might raise interest rates, which could lead to another severe hit to the economy.

As for 2009, the ongoing collapse of the housing bubble, the coming collapse of the commercial real estate bubble, and the ensuing wave of bad debt will all be major sources of drag on the U.S. economy — even if the dollar bust happens later.

Indeed, subprime mortgages were just the trigger for a much broader crisis. Plunging house prices are now leading to record default rates on prime loans as well, with most of the fallout ahead of us. We’ll also see much higher default rates on car loans, credit card debt, and other forms of consumer debt, because homeowners can no longer draw on their home equity to pay other debt.

Commercial real estate faces its own reckoning. When the housing market began to fade at the end of 2005, it kicked off a boom in nonresidential construction. In less than three years, this sector expanded more than 40 percent. There is now considerable excess capacity in retail space, office space, hotels, and other nonresidential sectors — leading to falling prices, plunging construction, and another major source of bad debts for banks.

In short, beware the happy talk from those who say we are "turning the corner," ignore the daily ups and downs of the market, and tighten your belts. This is going to hurt.

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