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Charles Wheelan, Ph.D. The Naked Economist

Charles Wheelan, Ph.D., The Naked Economist

Right on the Money

by Charles Wheelan, Ph.D.

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Posted on Wednesday, December 12, 2007, 12:00AM

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.

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64 Comments

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  • Zaheer - Friday, January 18, 2008, 9:09PM ET  Report Abuse

    • Overall: 4/5

    Most of you giving this article a negative rating haven't even bothered reading it. The author clearly mentions he is not forecasting. He is simply pointing towards some basic facts that one should keep an eye towards when the economy is acting funny. If it's so obvious, then why are we in this mess? maybe because people forgot about the basics, again ... And please stop endorsing Ron Paul. It makes you look like an even bigger idiot.

  • Johannes H - Sunday, January 13, 2008, 11:58PM ET  Report Abuse

    • Overall: 5/5

    The .com downfall is now well understood, so is the subprime morgage problem, but the deflation of the dollar is not a simple solution to a lot of USA problems. I am seeing that foreign goods will be more expensive so the USA is purchasing less from overseas and the USA goods are less expensive to the overseas customer, therefore they will purchase more USA goods. Now what is so bad with that?

  • Yahoo! Finance User - Tuesday, January 8, 2008, 1:00PM ET  Report Abuse

    • Overall: 5/5

    Deficits don't matter to those who don't care about our country's future. "Tax the children! They can't vote yet anyway!"

  • Yahoo! Finance User - Tuesday, January 1, 2008, 2:14AM ET  Report Abuse

    • Overall: 4/5

    Hmmm. Crash the local currency then buy up assets for cheap. Dubai just bought a piece of Nasdaq today. Well, did you think they were going to depend on us to keep buying their oil forever? I wonder when Americans will notice that the U.S. has become a 3rd world country. Well, perhaps now we can run around naked.

  • Hotblack - Monday, December 24, 2007, 10:30PM ET  Report Abuse

    • Overall: 4/5

    Good article, but I am surprised that you didn't mention the emergence of the Euro as a factor in the dollar's decline. For years the greenback has been propped up because it was the only currency for global business. Sure the pound, yen and mark all had a following, but none was accepted widely enough to be the world's staple currency. The past few years have seen the Euro become a closer runner up than any currency before it. Now that people have a better alternative to the dollar, there's less incentive to use it, hoard it and prop it up against the action of the US mint's round-the-clock printing presses.

  • Christian K - Saturday, December 22, 2007, 10:29AM ET  Report Abuse

    • Overall: 2/5

    It's a nice article but not more. Who is interested in a REAL and rather shocking analysis of the US economy should read one of the letters/speeches of Dr. Kurt Richebächer, the former chief-economist of Dresdner Bank (many of them available in english on the web).

  • Modified - Saturday, December 22, 2007, 10:22AM ET  Report Abuse

    • Overall: 5/5

    What is not stated is that the slide of the dollar is actually a TAX created by the Government in spending more than they take in. SO MUCH FOR NO NEW TAXES. The fact that it took 8 years before the tax took effect fooled a lot of people.

  • Yahoo! Finance User - Saturday, December 22, 2007, 8:30AM ET  Report Abuse

    • Overall: 2/5

    This is an average article written by an average economist -one able to predict the past. Where are these articles before the impending crisis? Ostensibly there has been much discourse about the declining dollar, but only once it starts happening are there being articles published. I see something much deeper underlying all this, each of his three points are successively more Real. The dot com bubble -people trading ownership on paper with no real value. Real estate -people selling off the very land they (once) owned. Now the dollar, perhaps the worst crisis in all, well it's the whole currency that not only the above is valued on, but that will effect anyone and everyone linked to it somehow. e.g. what's the point in owning a stock with an 8% dividend and/or 35% year-over-year growth if the value of the currency all the above is valued in is eroding by 40%? Many of the other comments are on Ron Paul, who wants the gold standard back, essentially revaluing the dollar as it stands now.... Is this a good thing? Do people including Ron Paul, understand the gold standard and/or why we came off of it and more importantly, the ramifications of going back to it? (I like the guy don't get me wrong, one of the best candidates we've got!) Or US industry, if more exports are what's needed, what companies are selling products over seas? Where is US industry going? I would like to see some articles that don't just restate the past as some epiphany, but some analysis about the situation as it is now and the consequences for the future. Anyone with a Ph.D. can say things are hard to predict, but an economist isn't an Oracle, but an analyst, where is the analysis in this article?

  • GlennG - Saturday, December 22, 2007, 1:08AM ET  Report Abuse

    • Overall: 3/5

    The article is very general, but it quickly highlights key points that people with minimal financial knowledge should be able to understand. Many commenters have referred to Ron Paul, stating that he is honest, has integrity, and other puffery. I don't know him personally, but I find it hard to believe that he is not just an average self-serving politician having been in office on and off since 1976. What has he accomplished during his terms in office? Until term limits are placed on Representatives and Senators in the U.S. Congress, and more importantly, voters stop voting for the same people that they gripe about (why in the hell do you vote for the same person every election when your life is hell?), the U.S. will continue to have a 3rd rate legislature.

  • Yahoo! Finance User - Saturday, December 22, 2007, 12:38AM ET  Report Abuse

    • Overall: 5/5

    Nice article. Thanks ! "Clear, concise, informative and (gasp) witty" as the folks over at the Chicago Tribune would say. I think I will order a copy of your book

  • Die Hard Libertarian - Saturday, December 22, 2007, 12:16AM ET  Report Abuse

    • Overall: 2/5

    Ron Paul would help get this country straightened out, but the problem is, no one wants to hear his message. I voted for him a few years ago when he was on the libertarian ticket for president. I wish he'd have stayed libertarian, instead of jumping back to the republicans. All the republican & demoocrat candidates are basically the same-- the only GOOD republicrat would be Ron Paul, but sadly, I'm voting libertarian to send the message this country is screwed up. The republicrats will only continue to screw it up!

  • Eric - Friday, December 21, 2007, 9:54PM ET  Report Abuse

    • Overall: 5/5

    I would just like to add something to this article in a manner that most Americans would understand - in the last 5 years, have you bought a $130,000 home for $350,000 on your $50,000 income with an ARM, bought that 52 inch HDTV on your Best Buy charge and that spankin' new Toyota Sequoyia and get a Shell gas card to drive it? Then you're part of the irresponsible vast majority causing this problem that's hurting the rest of us who live within our means.

  • Yahoo! Finance User - Friday, December 21, 2007, 9:47PM ET  Report Abuse

    • Overall: 3/5

    Ron Paul is the start of recovery for all of this financial mess that the bankers and the greedy military-government complex have created, with greedy citizens a willing partner in our own demise. He's the anti-politician. He's honest and he does not trade his votes for favors or money. He does not participate in the pork belly congressional pension program (imagine - a politican who is not constantly trying to extract more and more from the people!!). He believes in and votes for the constitution and NOT his own personal beliefs if they happen to conflict. For example, being an MD he personally believes in right to life. But he knows the constitution does not give the federal gov't the power to legislate this, so in political matters he puts his own personal beliefs on the back burner and always follows the constitution. I LIKE THAT!! He wants to abolish the federal reserve which is the heart of all inflation, literally. He wants to cut the federal income tax to ZERO and pay for it by returning to Y2K federal spending levels which includes no war (it's almost 1/2 trillion dollars right now and rising): http://nationalpriorities.org/cms/costofwar YES, federal income tax CAN be abolished if we only live with smaller government! Dr. Paul has been studying economics for MANY years and has served on the house banking committee. Don't kid yourself into thinking he doesn't understand how money works because he knows more than you do and has seen FAR more than we have about how things work in the back room where you and I are not allowed. RON PAUL is the ONLY candidate that will follow through with his promises. There are liars and damned liars and then there is a whole different class of uber-liar which includes every single presidential candidate except Ron Paul. If you don't vote for Dr. Paul, you deserve exactly what you get. The rest will start to mimic him as the economy spirals downward, but he is the only one with the political will to take on the same old, good old boy system that is turning the rest of us into increasingly lower paid slaves who will soon not be able to get by without a handout from the gov't. At the end of the day it's not about money, but rather about control. Google Ron Paul if you want to read some good news. Vote Ron Paul if you want to make a positive difference.

  • Mike V - Friday, December 21, 2007, 9:01PM ET  Report Abuse

    • Overall: 1/5

    Doc, I have to say, thats one man's opinion. Here's another mans.... Clues in a bubble...wall street smoke and mirrors ponzi scheme. Lessons from a collapse...greedy lenders making loans they never should have. Did they ignore Federal lending standards? Or is "The Fed" to blame for such lax standards? Mortgage backed securites...LOL. Incredible shrinking dollar...All you have to do is look at M3-money supply-that was going parabolic...before they stopped reporting it. We're in the vertical line phase of that parabolic graph right now, and have been for years. Now, where's my PhD? Oh, and BTW, if retail sales are so strong in Nov being up 1.2%, but inflation according to Benny is about 4% (when we all know its over 10%), aren't sales actually DOWN significantly? Yes folks, we ARE in a recession.

  • Yahoo! Finance User - Friday, December 21, 2007, 7:58PM ET  Report Abuse

    • Overall: 1/5

    I'd make some comments, but they would probably be deleted so why bother.

  • tim - Friday, December 21, 2007, 7:35PM ET  Report Abuse

    • Overall: 2/5

    Good article if you're looking for definitions, but as Dr. Wheelan himself states, I could look this up on page 220 of a MacroEcon text book. So Dr., please let me know if you think we are in the beginnnig, middle or end of the dollars decline.

  • Display - Friday, December 21, 2007, 6:10PM ET  Report Abuse

    • Overall: 5/5

    Very good comments. I suggest to all the read the book EMPIRE OF DEBT (2006) by Bonner and Wiggin. It is a reckoning.

  • Nemo - Friday, December 21, 2007, 4:45PM ET  Report Abuse

    • Overall: 4/5

    Thanks, Dr. W. for yet another method of expressing the First Law of the Universe: You don't get something for nothing. It applies to thermodynamics, motion, chemistry, dieting, economics, and even personal relationships. Yet it is always the hardest lesson for humans to learn.

  • LouieD - Friday, December 21, 2007, 4:25PM ET  Report Abuse

    • Overall: 5/5

    This is a very well written and easy to understand summary of some basic economic realities. If I had an argument, it would be with the author's interpretation of the housing debacle and the value of a home being linked to the rental income that home might bring in. His argument is correct but there are many areas of the country (like many resort areas) where there is a limited supply of lots to built on which is reflected in home prices being higher high demand and limited supply. In those cases, the rental income is not the issue.

  • bill - Friday, December 21, 2007, 4:10PM ET  Report Abuse

    • Overall: 4/5

    very good ! i will give chuck an excellent rating if he would tell us how to profit from this mess !

  • Not - Friday, December 21, 2007, 3:54PM ET  Report Abuse

    • Overall: 4/5

    I thought this was a very good informative article. Many people don't know what weakens the dollar. To those who chastised Mr. Naked for repeating what everyone seemingly knew, why wouldn't you write about something new and original?

  • walter - Friday, December 21, 2007, 3:47PM ET  Report Abuse

    • Overall: 1/5

    a lot of meaningless meanderings Nemo

  • MaryD - Friday, December 21, 2007, 3:01PM ET  Report Abuse

    • Overall: 5/5

    --An irrefutable conclusion: In the USA, the rulers are one entity, and the ruled are another, separate, entity. The ruled reflexively use numbers of dollars as a kind of rough unit of measure, saying such things as "That house must be worth $5 million," while the rulers act to change the supposed unit of measure. (Later a $5 million-house may resemble a doghouse, or it may resemble something grander than the Taj Mahal, according to the changes the rulers make in the dollar. The rulers usually hope the changes won't happen within one lifetime). Unless and until the ruled understand that the rulers are a separate entity and are controlling the amount of spending-power they have, regardless of numbers of dollars, they will continue to be fooled in this way.

  • DavidO - Friday, December 21, 2007, 2:44PM ET  Report Abuse

    • Overall: 3/5

    I imagine we're feeling what the Greeks, Romans, Mores, Huns, Germans, Brits, et al, felt as they watched their empires crumble. The common denominator is, and always will be, greed and arrogance. History repeats but the lessons are never learned.

  • Yahoo! Finance User - Friday, December 21, 2007, 2:33PM ET  Report Abuse

    • Overall: 1/5

    Interesting topic, but the article should go beyond generalities, it lacks depth.

  • Jim - Friday, December 21, 2007, 2:11PM ET  Report Abuse

    • Overall: 5/5

    I also wish he had continued with his discussion,, The U S will continue to have a weaker currency; will continue to have only service type jobs and opportunities; we will probably become the world's playground and education center; Home values will drop back to the local rental equivalents in every city, which may include losses of up to 75% from 2005... primarily because most of the jobs that paid for the housing boom will be gone... Those who work for companies with a global reach will be protected to some degree... no raises though for awhile.. I do agree that the dollar will ultimately start to rise again (from the ashes); I'm just not sure I want to be here when it does...

  • JayE - Friday, December 21, 2007, 2:10PM ET  Report Abuse

    • Overall: 5/5

    Ron Paul is an idiot. He proposes to eliminate the income tax and replace it with nothing - no VAT, national sales tax, nothing -, thus appealing to anarchists among us, yet at the same time he says he will continue to pay SS to those who have paid into the SS system. There IS no SS trust fund - WAKE UP! - to pay these obligations, yet he proposes to do so anyway. Of course, he also proposes to eliminate the national debt. How do you do all of this at the same time? Where does the money come from? Cutting off those who year after year have paid into programs such as SS and unemployment ane worker's comp is nothing short of legal theft.

  • Yahoo! Finance User - Friday, December 21, 2007, 1:43PM ET  Report Abuse

    • Overall: 2/5

    "Thank you for stating the obvious once again Mr. Naked". What is it about Yahoo finance that allows these kind of articles to be published. OK, so hindsight is 20/20. Can you please give me some foresight instead? The useful thing was that the authoer quoted Herb Stein. Using Stein's argument, can you tell the people that we simply can't afford to continue to have lower taxes and big spending and some day an American adminstration will have to auction huge pieces of public property to finance the economy bankrupted by decades of fiscal irresponsibility. What has been happening is that huge amounts of money were transferred from the public treasury to the big corporations and wealthy individuals saddling the American people with $9.5 Trillion (and counting). It's called "privatizing the gain and socializing the cost" to quote Noam Chomsky. In few years, when you cross Triboro or Golden gate bridge you will be paying toll to the Chinese government. Oh, and the term "Free way" that California is so used to. It will be a misnomer because we can't afford to keep them free. This great country was blessed with wealth beyound belief, but as long as it doesn't have people who REALLY care about it and demand to be told the truth then it will continue to be driven toward the cliff by the government and its pundits. We have been artificially keeping the inflation at bay. In reality inflation is all around us and the fact that the salaries have been kept low does not really help controlling inflation. It will only cripple the purchasing power of the people who, by the way, account for 2/3 of the American economy. Talk about shooting oneself in the foot! When we say that real estate is over priced and the formula is simple. See how much you can rent it for! Well, have you considered the cost of building that house if you want to build it today? Have accounted for the fact that this country is not generating new land and with the increase in population, the price of land has to go up? I really don't believe that real estate is overpriced. Check housing prices in Europe and you'll see that they are even higher. It is the people that are being pushed towards poverty and thus can't afford those homes. The falling dollar will exacerbate this problem, by the way.

  • lookin-for-ufc-fight - Friday, December 21, 2007, 1:27PM ET  Report Abuse

    • Overall: 1/5

    The Federal Reserve and the Federal government try to defy the basic rule of economics by printing more and more money. I agree with the previous comment: vote Ron Paul - restore the gold standard, get rid of the Federal Reserve and get us out of Iraq. Ron Paul - restoring our economy and our liberties.

  • my-email - Friday, December 21, 2007, 1:23PM ET  Report Abuse

    • Overall: 1/5

    A Doctorate in what, stating the obvious? No, wait, his Doctorate must be in "telling people what someone else already said." VOTE RON PAUL - 2008

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