Exchange Rates, Deficits, and Risk

The reason foreign prices of the U.S. dollar decline is usually that people no longer want to hold as many U.S. dollars as they did. One reason not to want to hold U.S. dollars is concern that the risk of doing so has increased. This is precisely the point made by Alan Greenspan. From the NY Times (free registration required):

"Current account imbalances, per se, need not be a problem," he said in a characteristically technical speech, "but cumulative deficits, which result in a marked decline of a country's net international position - as is occurring in the United States - raise more complicated issues."

Mr. Greenspan said foreign investors, in part because they fear having too much money at risk in the United States, would eventually become reluctant to take on more such assets.

The major risk facing foreign holders of U.S. dollars is not that the U.S. will default on its T-bills; rather, it is that the U.S. will increasingly monetize its debt and create inflationary pressures. The risk of future inflation is a risk that those folks left holding U.S. dollars will not be able to buy as much with them in the future as they can now. To some extent they can hedge against this risk in the forward markets, but if many people become concerned about this risk, the impact of their sales in the forward markets will have repercussions in the spot market.

Update (link from Newmark's Door). You want to read more about economic risk in the U.S.? Read this.