Charles Wheelan, Ph.D. The Naked Economist

There are important lessons to be learned from the dollar's fall. That doesn't mean I know what will happen to it next year.

This shouldn't be as surprising as it seems -- it's hard to predict short-term price movements for any asset. Think about it: If we all knew that the stock market would be up 10 percent next year, then who would be selling stocks at lower prices now? Any rational seller would either wait to get the higher price at the end of the year, or demand a chunk of that 10 percent premium immediately.

This sentiment was confirmed for me recently when I saw Harvard economist Ken Rogoff (a former professor) quoted in The Economist (a former employer) declaring that "it is stunning how hard it is to explain movements in exchange rates." I'm not certain of many things, but one of them is that Ken Rogoff knows a lot more about currencies than I do. (He's also a better chess player, but that's another story.)

Nothing Lasts Forever

This is the third time in the past decade that economic fundamentals have predicted a major correction: the dotcom bubble, the housing debacle, and now the dollar's slide.

No one knew exactly when any of them would happen -- not even in what year. But in each case, the economic writing was on the wall. Basic analysis suggested that we were in the midst of an unsustainable trend. Internet stocks, housing prices, and the dollar all fell prey to economist Herb Stein's admonition that anything that can't go on forever must stop.

Those who paid attention to the fundamentals made money from the eventual corrections (e.g., investing in euro-denominated bonds), or more likely, simply avoided making expensive mistakes (e.g., loading up a retirement account with shares of dotcom companies that no longer exist).

Clues in a Bubble

So what were the clues?

In the case of the dotcom bubble, the problem was that stock prices had come untethered from the underlying value of the asset. Too many people forgot that a stock is not a lottery ticket, or a collectible to be kept in the garage and sold later to someone else at a higher price.

A share of stock represents an ownership stake in a company -- and a corresponding share of the profits. If there are no profits, then there's not much point in owning the stock. Remember the knuckleheads who insisted that there were "new metrics" for evaluating Internet companies?

It was nonsense at the time, as well as in hindsight: There are plenty of intermediate benchmarks in any business, but the only thing that matters for the value of a stock in the long run is the money it puts in shareholders' pockets.

Lessons from a Collapse

The housing collapse was a variation on the same basic theme. Prices kept going up primarily because people thought prices would keep going up. In many markets, real estate prices had drifted far above the inherent value of the property. How can we determine how much a "home" is worth? Fairly easily, it turns out.

You can do two things with a house or condominium: You can live in it, or you can rent it out. For rental properties, the purchase price should bear some relationship to the expected rental income. If rents are going up sharply (or are expected to in the future), then it wouldn't be surprising for property values to be going up sharply, too.

But it's a yellow flag for economists if real estate prices skyrocket while rents are flat. It's similar to stock prices rising sharply without any increase in expected corporate profits. Why would investors pay more for the same expected stream of income? They shouldn't -- but that's exactly what was happening in many "hot" real estate markets around the country. Housing prices were going up while rents were not.

Obviously, most people buy a house to live in, not to rent out. But the value of the house you live in should still be highly correlated to its worth if you were to rent it out. In the most frothy real estate markets, that relationship broke down. Homebuyers were paying (for a while) much more than the best objective measure of what their properties were worth. That's now fixing itself, albeit painfully.

The Incredible Shrinking Dollar

And then there's the shrinking dollar. Policy types have been warning for years that the dollar was likely to depreciate significantly. (The fact that years went by without it actually happening gets to my earlier point about currency fluctuations being essentially unpredictable in the short term.)

The United States has been running large current account deficits. Basically, we buy more from the rest of the world than we sell to it -- and we borrow money (or sell assets) to pay the difference. That doesn't work forever; at some point our global creditors begin to wonder if they're going to get paid back.

For a variety of reasons, the most likely remedy for this imbalance is a fall in the value of the dollar relative to the currencies of our major trading partners, making imports more expensive and exports cheaper. This change in relative prices causes Americans to cut back on imports while foreigners are enticed to buy more of what we produce, narrowing our current account deficit.

It's the Economics, Stupid

Turn to page 220 or so in any standard macroeconomics textbook and you'll see something to this effect: A weakening currency is the mechanism that brings a current account deficit back into balance. To the extent that the United States has run large and chronic current account deficits, we shouldn't be shocked by the slide in the dollar.

In each case -- Internet stocks, the housing bubble, and now the dollar's slide -- the clues were there. Yes, that's hindsight. But it's not irrelevant.

The basic rules of economics are the same whether you're selling things over the Internet or out of the back of a covered wagon. Ignore them at your peril.