The value of the dollar is falling. Does
that mean that our economic sky is falling as well? Not to sound like
Chicken Little, but the answer may well be yes. If an economic collapse
is not in our future, then at least economic storm clouds are gathering
on the horizon.
It's what lies behind the slide of the dollar that has even many mainstream
economists spooked: an unprecedented current account deficit-the difference
between the country's income and its consumption and investment spending.
The current account deficit, which primarily reflects the huge gap between
the amount the United States imports and the amount it exports, is the
best indicator of where the country stands in its financial relationship
with the rest of the world.
At an estimated $670 billion, or 5.7% of gross domestic product (GDP),
the 2004 current account deficit is the largest ever. An already huge
trade deficit (the amount exports fall short of imports) made worse by
high oil prices, along with rock bottom private savings and a gaping federal
budget deficit, have helped push the U.S. current account deficit into
uncharted territory. The last time it was above 4% of GDP was in 1816,
and no other country has ever run a current account deficit that equals
nearly 1% of the world's GDP. If current trends continue, the gap could
reach 7.8% of U.S. GDP by 2008, according to Nouriel Roubini of New York
University and Brad Setser of University College, Oxford, two well-known
finance economists.
Most of the current account deficit stems from the U.S. trade deficit
(about $610 billion). The rest reflects the remittances immigrants send
home to their families plus U.S. foreign aid (together another $80 billion)
less net investment income (a positive $20 billion because the United
States still earns more from investments abroad than it pays out in interest
on its borrowing from abroad).
The current account deficit represents the amount of money the United
States must attract from abroad each year. Money comes from overseas in
two ways: foreign investors can buy stock in U.S. corporations, or they
can lend money to corporations or to the government by buying bonds. Currently,
almost all of the money must come from loans because European and Japanese
investors are no longer buying U.S. stocks. U.S. equity returns have been
trivial since 2000 in dollar terms and actually negative in euro terms
since the dollar has lost ground against the euro.
In essence, the U.S. economy racks up record current account deficits
by spending more than its national income to feed its appetite for imports
that are now half again exports. That increases the supply of dollars
in foreign hands.
At the same time, the demand for dollars has diminished. Foreign investors
are less interested in purchasing dollar-dominated assets as they hold
more of them (and as the self-fulfilling expectation that the value of
the dollar is likely to fall sets in). In October 2004 (the most recent
data available), net foreign purchases of U.S. securities-stocks and bonds-dipped
to their lowest level in a year and below what was necessary to offset
the current account deficit. In addition, global investors' stock and
bond portfolios are now overloaded with dollar-denominated assets, up
to 50% from 30% in the early '90s.
Under the weight of the massive current account deficit, the dollar has
already begun to give way. Since January 2002, the value of the dollar
has fallen more than 20%, with much of that dropoff happening since August
2004. The greenback now stands at multiyear lows against the euro, the
yen, and an index of major currencies.
Should foreign investors stop buying U.S. securities, then the dollar
will crash, stock values plummet, and an economic downturn surely follow.
But even if foreigners continue to purchase U.S. bonds-and they already
hold 47% of U.S Treasury bonds-a current account deficit of this magnitude
will be a costly drag on the economy. The Fed will have to boost interest
rates, which determine the rate of return on U.S. bonds, to compensate
for their lost value as the dollar slips in value and to keep foreigners
coming back for more. In addition, a falling dollar makes imports cost
more, pushing up U.S inflation rates. The Fed will either tolerate the
uptick in inflation or attempt to counteract it by raising interest rates
yet higher. Even in this more orderly scenario of decline, the current
expansion will slow or perhaps come to a halt.
Imperial Finance
You can still find those who claim none of this is a problem. Recently,
for example, the editors of the Wall Street Journal offered worried readers
the following relaxation technique-a version of what former Treasury Secretary
Larry Summers says is the sharpest argument you typically hear from a
finance minister whose country is saddled with a large current account
deficit.
First, recall that a large trade deficit requires a large surplus of capital
flowing into your country to cover it. Then ask yourself, would you rather
live in a country that continues to attract investment, or one that capital
is trying to get out of? Finally, remind yourself that the monetary authorities
control the value of currencies and are fully capable of halting the decline.
Feel better? You shouldn't. Arguments like these are unconvincing, a bravado
borne not of postmodern cool so much as the old-fashioned, unilateral
financial imperialism that underlies the muscular U.S. foreign policy
we see today.
True, so far foreigners have been happy to purchase the gobs of debt issued
by the U.S. Treasury and corporate America to cover the current account
deficit. And that has kept U.S. interest rates low. If not for the flood
of foreign money, Morgan Stanley economist Stephen Roach figures, U.S.
long-term interest rates would be between one and 1.5 percentage points
higher today.
The ability to borrow without pushing up interest rates has paid off handsomely
for the Bush administration. Now when the government spends more than
it takes in to prosecute the war in Iraq and bestow tax cuts on the rich,
savers from foreign shores finance those deficits at reduced rates. And
cash-strapped U.S. consumers are more ready to swallow an upside-down
economic recovery that has pushed up profit but neither created jobs nor
lifted wages when they can borrow at low interest rates.
How can the United States get away with running up debt at low rates?
Are other countries' central banks and private savers really the co-dependent
"global enablers" Roach and others call them, who happily hold
loads of low-yielding U.S. assets? The truth is, the United States has
taken advantage of the status of the dollar as the currency of the global
economy to make others adjust to its spending patterns. Foreign central
banks hold their reserves in dollars, and countries are billed in dollars
for their oil imports, which requires them to buy dollars. That sustains
the demand for the dollar and protects its value even as the current account
imbalance widens.
The U.S. strong dollar policy in the face of its yawning current account
deficit imposes a "shadow tax" on the rest of the world, at
least in part to pay for its cost of empire. "But payment,"
as Robert Skidelsky, the British biographer of Keynes, reminds us, "is
voluntary and depends at minimum on acquiescence in U.S. foreign policy."
The geopolitical reason for the rest of the capitalist world to accept
the "seignorage of the dollar"-in other words, the advantage
the United States enjoys by virtue of minting the reserve currency of
the international economy-became less compelling when the United States
substituted a "punywar on terrorism" for the Cold War, Skidelsky
adds.
The tax does not fall only on other industrialized countries. The U.S.
economy has not just become a giant vacuum cleaner that sucks up "all
the world's spare investible cash," in the words of University of
California, Berkeley economist Brad DeLong, but about one-third of that
money comes from the developing world. To put this contribution in perspective:
DeLong calculates that $90 billion a year, or one-third of the average
U.S. current account deficit over the last two decades, is equal to the
income of the poorest 500 million people in India.
The rest of the world ought not to complain about these global imbalances,
insist the strong dollar types. That the United States racks up debt while
other countries rack up savings is not profligacy but a virtue. The United
States, they argue, is the global economy's "consumer of last resort."
Others, especially in Europe, according to U.S. policymakers, are guilty
of "insufficient consumption": they hold back their economies
and dampen the demand for U.S. exports, exacerbating the U.S. current
account deficit. Last year U.S. consumers increased their spending three
times as quickly as European consumers (excluding Britain), and the U.S.
economy grew about two and half times as quickly.
Global Uprising
Not surprisingly, old Europe and newly industrializing Asia don't see
it that way. They have grown weary from all their heavy lifting of U.S.
securities. And while they have yet to throw them overboard, a revolt
is brewing.
Those cranky French are especially indignant about the unfairness of it
all. The editors of Le Monde, the French daily, complain that "The
United States considers itself innocent: it refuses to admit that it lives
beyond its means through weak savings and excessive consumption."
On top of that, the drop of the dollar has led to a brutal rise in the
value of the euro that is wiping out the demand for euro-zone exports
and slowing their already sluggish economic recoveries.
Even in Blair's Britain the Economist, the newsweekly, ran an unusually
tough-minded editorial warning: "The dollar's role as the leading
international currency can no longer be taken for granted. Š Imagine if
you could write checks that were accepted as payment but never cashed.
That is what [the privileged position of the dollar] amounts to. If you
had been granted that ability, you might take care to hang to it. America
is taking no such care. And may come to regret it."
But the real threat comes from Asia, especially Japan and China, the two
largest holders of U.S. Treasury bonds. Asian central banks already hold
most of their reserves in dollar-denominated assets, an enormous financial
risk given that the value of the dollar will likely continue to fall at
current low interest rates.
In late November, just the rumor that China's Central Bank threatened
to reduce its purchases of U.S. Treasury bonds was enough to send the
dollar tumbling.
No less than Alan Greenspan, chair of the Fed, seems to have come down
with a case of dollar anxiety. In his November remarks to the European
Banking Community, Green span warned of a "diminished appetite for
adding to dollar balances" even if the current account deficit stops
increasing. Greenspan believes that foreign investors are likely to realize
they have put too many of their eggs in the dollar basket and will either
unload their dollar-denominated investments or demand higher interest
rates. After Greenspan spoke, the dollar fell to its lowest level against
the Japanese yen in more than four years.
A Rough Ride From Here
The question that divides economists at this point is not whether the
dollar will decline more, but whether the descent will be slow and orderly
or quick and panicky. Either way, there is real reason to believe it will
be a rough ride.
First, a controlled devaluation of the dollar won't be easy to accomplish.
Several major Asian currencies are formally or informally pegged to the
dollar, including the Chinese yuan. The United States faces a $160 billion
trade deficit with China alone. U.S. financial authorities have exerted
tremendous pressure on the Chinese to raise the value of their currency,
in the hope of slowing the tide of Chinese imports into the United States
and making U.S. exports more competitive. But the Chinese have yet to
budge.
Beyond that, a fall in the dollar sufficient to close the current account
deficit will slaughter large amounts of capital. The Economist warns that
"[i]f the dollar falls by another 30%, as some predict, it would
amount to the biggest default in history: not a conventional default on
debt service, but default by stealth, wiping trillions off the value of
foreigners' dollar assets."
Even a gradual decline in the value of dollar will bring tough economic
consequences. Inflation will pick up, as imports cost more in this bid
to make U.S. exports cheaper. The Fed will surely raise interest rates
to counteract that inflationary pressure, slowing consumer borrowing and
investment. Also, closing the current account deficit would require smaller
government deficits. (Although not politically likely, repealing Bush's
pro-rich tax cuts would help.)
What will happen is anyone's guess given the unprecedented size of the
U.S. current account deficit. But there is a real possibility that the
dollar's slide will be anything but slow or orderly. Should Asian central
banks stop intervening on the scale needed to finance the U.S. deficit,
then a crisis surely would follow. The dollar would drop through the floor;
U.S. interest rates would skyrocket (on everything from Treasury bonds
to mortgages to credit cards); the stock market and home values would
collapse; consumer and investment spending would plunge; and a sharp recession
would take hold here and abroad.
The Bush administration seems determined to make things worse. Should
the Bush crew push through their plan to privatize Social Security and
pay the trillion-dollar transition cost with massive borrowing, the consequences
could be disastrous. The example of Argentina is instructive. Privatizing
the country's retirement program, as economist Paul Krugman has pointed
out, was a major source of the debt that brought on Argentina's crisis
in 2001. Dismantling the U.S. welfare state's most successful program
just might push the dollar-based financial system over the edge.
The U.S. economy is in a precarious situation held together so far by
imperial privilege. Its prospects appear to fall into one of three categories:
a dollar crisis; a long, slow, excruciating decline in value of the dollar;
or a dollar propped up through repeated interest rates hikes. That's real
reason to worry.
If the United States Was an Emerging Market
If the United States was a small or less-developed country, financial
alarm bells would already be ringing. The U.S. current account deficit
is well above the 5%-of-GDP standard the IMF and others use to pronounce
economies in the developing world vulnerable to financial crisis.
Just how crisis-prone depends on how the current account deficit affects
the economy's spending. If the foreign funds flowing into the country
are being invested in export-producing sectors of the economy, or the
tradable goods sectors, such as manufacturing and some services, they
are likely over time to generate revenues necessary to pay back the rest
of the world. In that case, the shortfall is less of a problem. If those
monies go to consumption or speculative investment in non-tradable (i.e.,
non-export producing) sectors such as a real estate, then they surely
will be a problem.
By that standard, the U.S. current account deficit is highly problematic.
Economists assess the impact of a current account deficit by comparing
it to the difference between net national investment and net national
savings. (Net here means less the money set aside to cover depreciation.)
In the U.S. case, that difference has widened because saving has plummeted,
not because investment has picked up. Last year, the United States registered
its lowest net national savings rate ever, 1.5%, due to the return of
large federal budget deficits and anemic personal savings. In addition,
U.S. investment has shifted substantially away from tradable goods as
manufacturing has come under heavy foreign competition toward the non-traded
goods sector, such as residential real estate whose prices have soared
in and around most major American cities.
Capital inflows that cover a decline in savings instead of a surge in
investment are not a sign of economic health nor cause to stop worrying
about the current account deficit.
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