Wednesday, December 08, 2004

Bowling Over Dollars

What do you think the American public would do if it was revealed that al-Qaeda had a plan that could result in economic damage to the United States, and the world, on a scale that would make the financial impact of September 11 look like a minor expense? Whereas the World Bank estimated that September 11 costs totaled $80 billion worldwide, the new scheme, if events occur in a certain manner, could erase trillions from the global balance sheet. In the process, America's economy would be ravaged: a deep recession would set it in, the housing bubble would burst, America would lose its position of dominance in global markets, its credit rating and borrowing capacity would deteriorate to near third-world status, and a host of other economic maladies would befall the erstwhile economic giant.

The alarms would be going off, and hair would be blazing. Commissions would be convened, action would be called for, and strategies formulated in a flurry of activity. We would mobilize the vast resources of our government and economic sectors to counteract such an attack.

But what if the plan were being promulgated by the government itself, and not some foreign enemy wishing to do us harm? What if the plan were being sold as a panacea for our current economic malaise? What would the reaction be then?

That is precisely the conundrum now facing the American public, who remain largely unaware of the repercussions of the radical monetary policies being pursued by the Bush administration and the Republican leadership in Congress. The plan involves allowing, even encouraging, the dollar to drop against most of the world's major currencies.
The theory is that such a drop will help to reduce the current account deficit between the US and the rest of the world. This account deficit is a product of trade deficits, low domestic savings, high consumption, and, most importantly, borrowing from abroad to finance the federal government's staggering budget deficits (caveat: I am over-simplifying some of these intricate concepts for my own sake, and for the sake of the discussion, so to all the economists out there, I apologize for my butchery).

By lowering the value of the dollar, it is argued, the trade gap should lessen by making American exports more attractive and foreign imports more expensive. This would go a long way to improving the current account deficit which is perceived as a serious liability in the near future. By thus closing the gap, the US could reassure foreign interests and encourage their continued financing of US debt and financial activity. The problem is, there are dual goals that in some ways can come into conflict: in addition to attracting new investors and financiers, we must appease current creditors holding dollar assets. If the currency drops too far, creditors could be tempted to sell off their dollars, and the dollar could lose its status as the world's preferred currency. This could end up compounding the problems represented by our budget deficit by making it much harder to borrow abroad in the future to finance the debt despite the gains made in closing the trade gap. It is not clear that the Bush administration's economic team is insuring a gradual decline that more closely resembles a healthy correction and avoids a run on dollars. The current descent is triggering fears, and a mild panic on the part of some creditors.


Dating back to the World War II era, the dollar has been the dominant reserve currency for the world. This has afforded significant economic benefits for the United States, including the ability to pay for imports using dollars, and borrow at very low interest rates. This coveted status should not be taken for granted, as this article in the
Economist suggests:
...The privilege of being able to print the world's reserve currency, a privilege which is now at risk, allows America to borrow cheaply, and thus to spend much more than it earns, on far better terms than are available to others. Imagine you could write cheques that were accepted as payment but never cashed. That is what it amounts to. If you had been granted that ability, you might take care to hang on to it. America is taking no such care, and may come to regret it.
If the dollar falls out of favor, the money we would need to borrow to finance our debts would be harder to come by, and more expensive to acquire. The recent trajectory of the dollar is enough to cause some concern. Over the past three years it has fallen by 35% against the euro and by 24% against the yen, and since as recently as mid-October the dollar has fallen by approximately 7% against the other main currencies - while hitting a new all-time low against the euro and a five-year low against the yen. In terms of global usage, the dollar's share of global foreign-exchange reserves has fallen from a height of 80% in the mid-1970s to around 65% today. Still, despite the decline, it takes a particularly unique confluence of events to bring down a dominant global currency. According to a separate Economist article:

In 1913, at the height of its empire, Britain was the world's biggest creditor. Within 40 years, after two costly world wars and economic mismanagement, it became a net debtor and the dollar usurped sterling's role. Dislodging an incumbent currency can take years. Sterling maintained a central international role for at least half a century after America's GDP overtook Britain's at the end of the 19th century. But it did eventually lose that status.
Defenders of the current devaluation regime point to the fact that many of the same fears were raised in the mid-1980s and early 1990s, both periods of prolonged decline of the dollar that in the end did not spell the death knell for the greenback. But at those times, there was no competing currency capable of replacing the dollar. The luxury of being without a rival may be passing into history as well with the emergence of a new force in Europe.

The requirements of a reserve currency are a large economy, open and deep financial markets, low inflation and confidence in the value of the currency. At current exchange rates the euro area's economy is not that much smaller than America's; the euro area is also the world's biggest exporter; and since the creation of the single currency, European financial markets have become deeper and more liquid. It is true that the euro area has had slower real GDP growth than America. But in dollar terms the euro area's economic weight has actually grown relative to America's over the past five years.

The euro area, unlike America, is a net creditor. Never before has the guardian of the world's main reserve currency been its biggest net debtor. And a debtor may be tempted to use devaluation to reduce its external deficit—hardly a desirable property for a reserve currency.
Others have suggested that the next monetary paradigm shift might not involve a clean switch to a new master, but rather a gradual balkanization of the reserve currency system resulting in a mosaic of the dollar, euro, yen and possibly yuan in the not too distant future. Either scenario would not bode well for the American economy.

The Cost

Pursuing the current strategy of currency devaluation is like attempting to traverse a tight rope. If we can make it across to the end of the rope, we will succeed, and in this context we will preserve the dollar's status as the dominant global currency and our economic habits would continue to receive foreign financing and investment. But if the process tilts too far in either direction, the fall would be long and hard, and the net at the bottom might not quite cushion the impact. The danger is that one event can trigger a chain reaction of ever increasing magnitude. How effectively can Alan Greenspan or any member of the Bush economic team manage the decline of the dollar. If it goes too far too fast, catastrophe will ensue.

Many American policymakers talk as though it is better to rely entirely on a falling dollar to solve, somehow, all their problems. Conceivably, it could happen—but such a one-sided remedy would most likely be far more painful than they imagine. America's challenge is not just to reduce its current-account deficit to a level which foreigners are happy to finance by buying more dollar assets, but also to persuade existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion. A fall in the dollar sufficient to close the current-account deficit might destroy its safe-haven status. If 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.
If that "safe-haven" is lost, creditors will begin cashing the IOU's that they have thus far been content to hold in perpetuity, unpaid. Further, America will have to raise interest rates significantly on debt instruments in order to acquire the new financing it needs in order to meet its fiscal obligations going forward. This rise in rates will cause the real estate bubble to burst (as many homeowners are tied in to adjustable rate mortgages, and new mortgages will be more expensive) and dry up capital for investment, which would likely result in a deep and prolonged recession, which would further drag on the dollar in a self sustaining downward spiral.

Optimists argue that foreigners will keep financing the deficit despite the dollar's slide, and will not demand payment of debt instruments prematurely because American assets offer high returns and still a relatively safe cover from risk. This contention is undermined by evidence that private investors (not governments yet) have already been passing over dollar assets for more attractive options

...the returns on investments in America have recently been lower than in Europe or Japan. And can a currency that has been sliding against the world's next two biggest currencies for 30 years be regarded as "safe"?

Those bearish on the dollar are asking why investors will want to hold the assets of a country that has, by its own actions, jeopardised its reserve-currency position. And, they point out, without the intervention of central banks, which have been huge net buyers of dollars, the dollar would already be lower. If those same central banks were to begin to sell some of their $2.3 trillion dollar assets, then there would be a risk of a collapse in the dollar. However you look at it, America is likely to find it increasingly hard to finance its huge current-account deficit.
The fear is that the gap between the investment habits of private investors and governmental central banks is beginning to narrow, with both reaching the same conclusions about the appeal of dollar assets.

The Asia Factor

As alluded to above, there is a general consensus amongst economists, even the ones that support devaluation of the dollar, that in a free market of rational actors, without the massive support of Asian central banks, the dollar would be far weaker.

But Asian governments have been artificially propping up the value of the dollar by buying American treasury bonds, even though those bonds offer lower yields than their competitors, in order to sustain America's ability to spend money in Asian markets. This monetary life support system cannot go on forever though, and if the Asian well dries up, the tightrope walker tumbles.

Despite their mercantilist instincts, sooner or later Asia's central banks will have to face the fact that they are holding far too many risky, low-yielding dollars. If they stop buying, it could trigger a sharp fall in the dollar and a jump in bond yields.
Another argument involves what Larry Summers, a Treasury secretary under President Clinton, calls the "balance of financial terror." This theory contends that Asian banks are so awash with dollar assets that they can't afford too steep a drop in the dollar, or a default on our debt obligations, because their own dollar assets would lose too much value. In this sense, "America relies on the costs to Asian central banks of not financing its deficit as assurance that financing will continue indefinitely."

There are very troubling signs that despite these factors a lack of appetite is forming around the globe, even in Asia.

Markets have been rattled by concerns that foreign central banks might reduce their holdings of American Treasury bonds. Last week, officials at the central banks of both Russia and Indonesia said that their banks were considering reducing the share of dollars in their reserves. Even more alarming were reports that China's central bank, the second-biggest holder (after Japan) of foreign-exchange reserves, may have trimmed its purchases of American Treasury bonds.
If Asia begins to temper its American bond habits, it might serve as a wake up call to those, like the Vice President, who claim that "deficits don't matter." Asia has been complicit in creating the illusion that allows Cheney to get away with making such poorly reasoned statements.

The behaviour of Asia's central banks has also blunted the necessary market signals to which even America must, eventually, pay heed. The current-account deficit is a direct, arithmetical reflection of insufficient domestic saving. In particular, America needs to prune its government budget deficit. However, it feels even less reason than usual to do so. Normally, when a government's budget deficit swells so fast (to 4.6% of GDP this year, from a surplus of 2.4% of GDP in 2000) and its currency is falling, investors would demand higher bond yields to compensate them for the increased risk. That penalty gives governments both a warning and an incentive to borrow less. But Asian governments are devouring American Treasury bonds with little regard for the usual risk-return characteristics. As a result, bond yields are being held artificially low, subsidising America's borrowing spree.
The Solution

Some depreciation in the dollar might not be a bad thing in the long run considering the need for America to reduce its current account deficit, and the fact that the dollar's value might be slightly inflated. The present course of action, however, is reckless in its disregard for massive devaluation which could cause the world to switch to euros or a combination of currencies - which would lead to a whole parade of horribles. The truth is, such extreme measures are not needed to achieve the desired effect. Of course, confronting the problem in a more reasonable way would require a return to good old fashioned conservative fiscal discipline, which would entail a rolling back of the enormous tax cuts that primarily benefited the wealthiest Americans. If only conservatives were in charge of such decisions.

In any case, the current-account deficit cannot be corrected by a fall in the dollar alone: domestic saving also needs to rise. The best way would be for the government to cut its budget deficit. That would reduce America's need to borrow from abroad, and so mitigate the fall in the dollar and rise in bond yields that will otherwise be demanded by investors. If combined with stronger growth abroad, then the current-account deficit could slowly shrink. America's growth would be depressed by tax increases or spending cuts, but there would be no need for recession. If, on the other hand, the government fails to cut its budget deficit, the dollar will fall more sharply and bond yields will rise. America's housing bubble might then burst and consumer spending would certainly slow sharply. That combination would reduce the external deficit, but only at the cost of a deep recession.
Given the risks involved in trying to make devaluation of the dollar the sole remedy for the account deficit that plagues our economy, wouldn't balancing the budget, even if it meant sacrificing a portion of Bush's tax cuts, be a welcomed alternative? Saving the dollar, preserving our privileged status, averting a recession, keeping interest rates under control, and shielding the housing bubble all seem well worth the cost of some tax cuts to the people who need them least, at a time when our most pressing economic needs are not economic stimulus. The willingness to sacrifice the dollar at the altar of tax cuts is, dare I say it, un-American.

[Update: Dan Conley (hat tip to jonnybutter) has some interesting things to add to this discussion, including an excerpt from an article that suggests that dollar devaluation might not really be a remedy for our current trade deficit. The argument goes like this: even if the dollar depreciates nominally, it would not be enough to suddenly allow consumers in places like China, Japan, India and elsewhere to buy American goods. The gap in currency values is too stark for a mild correction to erase. Similarly, current importers of goods like Wal-Mart would still not be incentivized to stop importing goods because the foreign made products will still be cheaper and the outsourced manufacturing facilities more cost effective. The dollar can't drop far enough to have an impact in this dynamic. Here is a quote from the article Dan cites:

"It is generally accepted these days that the continued debasement of the U.S. dollar is a positive. It is also generally accepted to expect that as the buck declines, the U.S. trade deficit will correct itself, like a self-cleaning oven, we have been led to suppose. But upon pondering this 2004 rule of thumb, a question came to mind. Perhaps you can answer it. Here goes:

"At what dollar/yuan (or dollar/won or dollar/anything) level will overseas manufacturers lose the cost-competitive edge to where, say, a Wal-Mart Stores (WMT, news, msgs) (or any other U.S. entity that's contributing to our gaping trade imbalance) will eschew Asia and opt for domestically produced goods? Simply put, how low do we have to push the buck before a 42" TV is cheaper from Sheboygan than from Shenzhen?

"Right off the bat, I'd have to surmise that we won't ever experience that phenomenon, because long before it came anywhere even close to that, the inflation would have eaten us all alive. . . . You still wanna argue about the benefits of a weaker dollar because this will lower our imports and raise our exports with a view to meaningfully closing the trade gap? This of course would encompass the glitch of how to market a U.S.-made $2,200 Maytag Neptune washer/dryer combo to that guy in Nanjing who is pullin' down a cool 76 cents per hour. . . .
Tough questions. The conclusion is the same however: cut the budget deficit or reap the whirlwind.]

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