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Falling $, Record Oil

Amplifying the economic fallout from the subprime shock was a dramatic fall in the value of the U.S. dollar. The two were related: The housing bust had occurred in the U.S. at a time when financial and economic conditions elsewhere around the world were measurably better. Global investors who had been eager to put their cash into U.S. markets prior to the shock were now just as eager to get out.

As a result, the dollar tumbled in value against other major world currencies. The euro moved up from $1.35 to almost $1.60; the Canadian loonie rose from 85 U.S. cents to $1-for-$1 parity (the first time since the early 1970s); and instead of needing 125 Japanese yen to make $1, traders needed only 100. Together, the dollar's value (measured against the currencies of America's major trading partners) fell more than 10% in just a few months in late 2007 and early 2008. This was on top of a 15% decline during the Iraq invasion and deflation scare earlier in the decade. The dollar was worth about one-fourth less than at its peak.

This wasn't an entirely bad thing. There were clear economic benefits to the weaker dollar. When combined with stronger growth overseas, the U.S. trade deficit narrowed. The imbalance between U.S. imports and exports had, in fact, peaked with the housing market in late 2005; by early 2008 it had been cut by a fourth.10 The nation's agriculture, aerospace, machine tools, and technology industries gained new market power overseas and shipped record amounts of goods to Asia, South America, and Europe. After years of weighing down the economy, trade had become a key source of growth.

The dollar's sharp drop in the midst of the financial turmoil did more damage than good, however. It helped ignite another surge in oil, food, and other commodity prices. Since most commodities trade globally in dollars, a fall in the dollar's exchange value means the dollar price of these commodities must rise to maintain a balance between global demand and supply. Given the increasing values of the euro, yuan, and rubble vis-à-vis the dollar, without a higher dollar price for oil, wheat, and copper, the Europeans, Chinese, and Russians will consume more, throwing demand and supply off kilter. As a result, a barrel of oil that sold for $65 in the weeks leading up to subprime shock had doubled in price by spring 2008.

The dollar price of other commodities ranging from gold and wheat to copper and coca beans didn't rise quite as much, but most were still hitting record highs. Commodities weren't being powered by a weaker dollar alone. The financial bedlam created by the subprime shock also contributed. Global investors were truly confused about where to put their money. Real estate was certainly out, bonds seemed like land mines, and stocks appeared shaky at best.

Each new explosion in the financial markets drove investors to seek safer investments mainly U.S. Treasury securities and commodities. Some investors reasoned commodity prices tended to move in the opposite direction of other asset prices and would thus help diversify their portfolios. Other short-term investors, so-called momentum players, simply bet that because commodities had been consistently rising in price, they would rise even further. The commodity markets were like any other asset market in an age of easy trading and excess liquidity; here too, prices could be subject to speculation and bubbles.

For the economy, surging oil and other commodity prices were too much to bear. The price of a gallon of regular unleaded gasoline, which had averaged $2.75 nationwide on Labor Day 2007, reached $4 by Memorial Day 2008 and kept rising. Each penny increase increased Americans' driving costs by more than $1 billion. Washington's $100 billion tax rebate part of the fiscal stimulus passed a few months earlier to try to stave off recession began arriving in Americans' mailboxes just as gasoline crossed $4, and was effectively gobbled up by the higher cost of fuel.

Observers noted a bitter irony: The U.S. Treasury had sold bonds to raise the cash to pay the tax rebates which were spent to buy oil from the same nations that had purchased the bonds. It's not much of an exaggeration to say that countries such as Saudi Arabia had essentially financed the purchase of their own oil. Energy wasn't the only thing that was rising quickly in price. Food prices were also up sharply. This was driven partly by the higher cost of moving farm products to store shelves as diesel prices soared; but it also reflected the weak dollar and strong global demand for all U.S. agricultural products. Imported goods of all kinds cost more.

Even prices for goods coming from China, which had fallen for years, were now on the rise. It was the reverse of the late 1990s, when the Asian financial crisis had sent investors scurrying to the safety of the U.S. This lifted the dollar and slashed the price of imports to U.S. consumers. The subprime financial shock induced global investors to flee American markets, undermining the dollar and raising prices for anything not made in the U.S. Consumers were rightly panicked, realizing there was no way out and that recession was unavoidable.