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The shrinking currency of technology

A falling dollar has been good for U.S. high technology, but CNET News.com's Declan McCullagh explains why the good times may be coming to an end.

For the moment, U.S. technology companies have reason to celebrate a dollar that has been declining gradually but steadily in value.

Between January and December 2003, the dollar fell 20 percent against the euro. Thanks to the sliding greenback, Amazon reported a jump in quarterly revenue last week that helped make 2003 the company's first profitable year ever. Microsoft, IBM and Cisco Systems have also recently attributed increased sales to the weaker dollar.

But what about the longer-term effects?

For a glimpse, look to Washington, D.C., where President Bush on Monday will release his proposed budget for the federal government's 2005 fiscal year. It's expected to project a record deficit of $521 billion, up from $375 billion for 2004.

Currency markets are notoriously complex, but the most probable causes of the dollar's fall are the twin U.S. trade and budget deficits.

Over time, a sliding dollar will reduce the cost savings U.S. firms might enjoy when moving operations overseas.
Fortunately, the trade deficit tends to be self-correcting: If it balloons too far out of shape, the dollar falls, making U.S. exports more attractive, which shrinks the trade deficit.

Not so with the federal budget deficit. Combine the Bush administration's profligacy with a lack of restraint in Congress, and the deficit has skyrocketed to ever-higher altitudes--with no obvious limit on the horizon. And if that continues, tech stocks could suffer.

"If a government budget deficit gets too large, then foreign investors might worry about the stability of the U.S., the future tax rates of the U.S. (necessary to pay off the debt), so they become less likely to invest here," said Don Boudreaux, chairman of the economics department at George Mason University. "So the demand for dollars to invest falls." (The former chairman of Citibank, Walter Wriston, put it succinctly: "Money goes where it is welcome and stays where it is well-treated.")

Robert Rubin, the former chairman of Goldman Sachs who became Treasury Secretary in the Clinton administration, felt the same way. "These kinds of occurrences are not without consequences," Rubin said in a 1996 interview with The New York Times, adding that he kept the dollar high, because a falling dollar tends to drive investors out of American stocks, bonds and Treasury debt. "It would take a while to show up, but I'm certain it would have happened."

That's why, if the dollar is going to fall, a quick, steep decline in its value is probably better than a gradual one--which gives foreign investors more time to bail out of U.S. stock and bond markets that are losing value against other markets. A speedy fall would "wipe out the asset devaluation risk in one fell swoop and make U.S. assets cheap and attractive to foreign buyers once again," Korkut Erturk, chairman of the economics department at the University of Utah, wrote in a paper published in December.

The offshore factor
Other downsides to a weak dollar are more obvious. All else being equal, U.S. firms and consumers end up paying more for products made elsewhere. Imported goods make up about 12 percent of the U.S. gross domestic product, and plenty of computer components are imported from overseas.

More than just foreign companies are affected. Because U.S. tech firms have been shifting operations outside the country, a weak dollar means that those facilities are more expensive to operate and that those workers cost more to employ. Seagate has moved some hard-drive manufacturing overseas, and Advanced Micro Devices' next microprocessor fabrication facility is being built near Dresden, Germany. Intel said in August that it would build a microprocessor-testing and assembly plant in the Chinese city of Chengdu, in addition to the one it already operates near Shanghai.

Over time, a sliding dollar will reduce the cost savings U.S. firms might enjoy when moving operations overseas. This may help employees of technology firms in the United States in the short term, of course, but not shareholders, who will not gain as much value, or consumers, who will pay higher prices.

"A falling dollar can hurt American tech companies directly by, for example, making it more costly to outsource or to buy supplies for their factories," George Mason's Boudreaux said. "It can be hurt by the same larger factor that's causing the fall in the price of the dollar: a bad investment climate, in general, caused by the threat of higher taxes, budget deficits or trade deficits."

When the dollar becomes very weak, the Federal Reserve tends to raise interest rates in a bid to make the United States a more popular place to invest. That would be especially bad news for the tech sector. More than established companies, younger technology companies rely on venture funding and outside investment to expand: How many sizable start-ups are entirely funded by their founders? Steeper interest rates will make it more expensive for entrepreneurs to seek loans and could make savings accounts and government bonds relatively more attractive than the stock market.

While that's not a particularly savory outcome, neither is a spike in inflation, another consequence of the spendthrifts in Washington constantly seeking to boost government spending. True, it's not inevitable, but history tells us that it's possible. Federal Reserve Governor Ben Bernanke acknowledged as much in a speech last November that said "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

All this can still be averted, if Congress shows some fiscal discipline, trims down the proposed budget and refrains from running up America's credit card bill. But in an election year, that may be expecting too much of a good thing.