Dollar’s Skid Could Spark Big Trouble Policy-Makers Fear Results If Decline Triggers Stampede

Try to imagine yourself as a Japanese banker with a billion dollars in U.S. Treasury bonds or a German manufacturer with a couple of million in a U.S. bank account.

Since the start of this year, the value in Japan of your American bonds has dropped a breathtaking 20 percent and the value in Germany of the money in your U.S. bank account has slid nearly 13 percent.

Now ask yourself: would you continue to hold your dollar investments?

The question is central to a frightening meltdown scenario that is keeping U.S. policy-makers awake at night and currency traders on edge.

If there were a stampede from the dollar, it could send the currency into a downward spiral, trigger panic selling in the stock and bond markets and force the Federal Reserve to raise interest rates, ensuring pain enough for everyone.

But it gets worse: The U.S. economy would fall into a recession, unemployment would rise and what seemed like a crisis confined to Wall Street would make its way to Main Street.

So far, few economists or investment managers are taking such a grim scenario seriously. Yet few thought the dollar would sink so far so quickly. And it’s harder to brush off a worst-case possibility when the dollar is only fetching 83 yen instead of the 100 yen it brought at the start of the year.

The question haunts. As the value of the dollar continues to drop against the yen and mark, at what point do foreign investors say, “This is crazy,” take their money and run?

“I’ve been surprised that we haven’t seen it yet,” said Peter Kenen, an economics professor at Princeton University. “I expected the falling dollar to translate into falling stocks and bonds and then have the two feeding off each other. We seem to be taking this all in stride.”

For the moment, the dollar’s steep decline hasn’t reached a point where it is going to crimp the lifestyles of most Americans.

The costs of Japanese and German imports are certainly starting to rise, but the increases will be incremental and unfold gradually.

Even then, many economists point out that while the yen and mark have strengthened against the dollar, the currencies of other countries that account for many U.S. imports, such as Canada and Mexico, have declined.

That means that as Japanese and German products have grown more costly, Canadian and Mexican goods have become cheaper.

But big trouble could come over time, if the dollar continues to slide. At some point the dollar’s decline could cause foreign investors to lose confidence in the long-term health of the U.S. economy.

“It’s not something that will cause an explosion that you can see today,” said Anil Agarwal, a currency specialist for Brown Brothers Harriman & Co. “It’s a festering problem that could come back to haunt us.”

Agarwal said as the dollar erodes in value, foreign investors will demand more of a premium to hold U.S. investments.

If the dollar sinks much lower, the Federal Reserve will come under increasing pressure to raise interest rates as a way of maintaining the attractiveness of Treasury securities for foreign investors.

Investors, in essence, would be demanding a higher premium in the form of higher interest rates to assume the risk of holding dollardenominated investments.

U.S. consumers, in the end, would pay the price in the form of higher borrowing fees for homes, cars and credit-card purchases. The higher interest rates could seriously slow the economy or even send it into decline.