Posted by: Dale Franks on Tuesday, March 01, 2005 The editors of the Washington Post are worried about the dollar. The dollar's vulnerability reflects the nation's trade deficit. To sustain their appetite for foreign goods, Americans need to convert their dollars into other currencies, depressing the greenback's value. This didn't stop the dollar from being strong in the 1990s, because the trade deficit was smaller then and because foreign investors were hungry for American stocks, bonds and other assets, reflecting the U.S. economy's enviable performance. But now foreign investors' appetite for dollars lags behind Americans' demand for foreign goods and services. The gap is being filled by Asian governments, whose central banks have accumulated vast piles of U.S. bonds in an attempt to slow the dollar's slide.This is not an unrealistic worry. In the usual course of events, a nation running a massive trade deficit like the United States should, over time, see the value of it's currency fall in the FOREX market, and here's why. Let's say you run a German company that sells radios. Each radio sells for €100. If the euro's exchange rate to the dollar is 1:1, that means you can sell radios in the US for $100. Of course, after you sell a bunch of radios, you are going to want to bring those revenues back to the Fatherland, and so, you will have to exchange those dollars you got in the US for euros you can spend at home. That means you have to sell dollars and buy euros. If everybody else--the Chinese, Japanese, South Koreans- is selling dollars too, that means there's a glut of dollars, so the dollar trades for less against foreign currencies. Before you know it, the euro is now worth 1.20. In order to meet your price of &euro100 for a radio, you now have to charge your American customers $120. Hence, less Americans buy your radios. At the same time, American exports to Germany become less expensive. A $100 American product that used to sell in Germany for €100 now costs the German consumer only €80. So, American exports rise as German consumers buy more of the American product. In this way, trade deficits are supposed to balance out over the long run. That's the theory, anyway. The reality has been quite different. Export-led growth has been almost a religion with Asian economies. They've been very loath to see the value of the dollar fall for fear that it would affect their rates of economic growth. The Chinese have been especially concerned about this. As a result, they simply haven't been repatriating those US dollars back into their currencies. Instead, they've been buying US securities, mainly treasury bonds. This has financed our trade deficit and has kept the value of the dollar artificially high. For things to keep humming along as they have been, Asian governments have to be committed to doing this indefinitely. Keep that in mind for a few minutes, while we flash back several years. By the end of the mid 90's investors had been pouring massive amounts of cash into the Asian economies. In 1997, however, a speculative attack on the Malaysian rinngit set off a huge crisis. The Malaysian central bank was unable to support the value of the ringgit, and the value collapsed. This started a wave of Asian currency sales as investors bailed out of Asian investments. By the end of the 1990s, Asian currencies were in a shambles, huge business interests had gone bankrupt, and Asian stock markets had declined precipitously. Today, the US dollar is in a similar position as Asian currencies were in the late mid-90s. Foreigners hold its value artificially high because of massive investment. So, what happens if, say, South Korea decides that it's time to dump its dollar-denominated holdings? Well, one thing that could happen is that other nations might quickly follow suit, in an attempt to repatriate as much money as they could before the value of the dollar crashes. That would probably set up a panic run on the dollar causing the value to collapse anyway, in a perfect self-fulfilling prophecy. What is the evidence that something like this could actually happen? As the editors of the Post put it: Last week brought a warning to economic policymakers on both ends of Pennsylvania Avenue. A rumor that South Korea's central bank had decided to shift its reserves away from dollars triggered a sharp fall in the greenback and a retreat on Wall Street. The fact that the South Koreans later denied this rumor is only half-comforting. Economic logic is pushing Asia's central banks to quit propping up the dollar. If a hollow rumor can rattle the currency, what would a real policy change do?Asian bankers are keenly aware of the currency vulnerabilities of their massive US portfolios. If any major Asian economy decided on a policy change, the pressure to start selling the dollar would probably be pretty intense. This is not to say that the choice for Asian policymakers would be easy. Because Asian countries have tended to follow the Japanese model of export-led economic growth, they would have to be worried that such a drop in the dollar's value would be extremely damaging to their own economies. At the same time, holding on to US securities as a good portion of their value evaporates due to currency risk is an equally unappealing choice. That would put them in much the same position as Japan was in the 1990s. In the 1980s, the Japanese, trying to keep their exports humming along, invested massively in the US, buying all sorts of trophy properties, real estate, etc. At the time, everyone was worrying that the whole country was being bought by "Japan Inc.". But in the 1990 recession, the value of these properties plummeted, and the Japanese were holding the bag. Not only was the capital value of those properties worth literally pennies on the dollar, they were producing no revenues any more. Meanwhile, the slowdown in the US economy crippled Japanese exports, which required them to repatriate those American investments to meet their financial obligations in Japan. Eventually, the Japanese had to sell all those trophy properties back to Americans for pennies on the dollar. For all the talk about Japan Inc, we essentially soaked the Japanese for billions upon billions of dollars. And as a result, the Japanese spent the entirety of the 90s in the economic doldrums, trying to pay off their remaining massive corporate debt loads. So Japan spent the entire decade with subpar economic growth and massive debt. So Asian policymakers are in an uncomfortable little box, and the only way out of it might be to simply sell of their American holdings. The implications of that kind of policy change look potentially nasty for us. A massive sell-off of bonds, for example, would cause the prices to decline substantially, hence the yield, i.e. the effective interest rate, would skyrocket. At the same time, the price of foreign goods would shoot up, too. That would leave US policymakers with some nasty choices about how to simultaneously keep the economy moving while both interest rates and inflation were skyrocketing. Do you flood the streets with cash in order to buy those bonds back and keep interest rates low? If so, how do you try to keep the lid on inflation when you're pumping up the money supply? What makes this type of question even more pointed is also something that the Asian government's found out in the 1990s. When the FOREX began hammering on the ringgit like a cheap ten-penny nail, the Malaysian central bank poured money into supporting the ringgit like there was no tomorrow. Unfortunately, because they didn't have enough reserves to keep supporting the ringgit, there actually was no tomorrow. By the same token, the US is already $8 trillion in debt. If we had a lower debt level, and a balanced budget, we'd be a lot more able to come up with the reserves--even if it meant borrowing--to fight off a speculative run on the dollar. Even if we couldn't attract foreign investors, enough domestic investors would be willing to buy bonds to cover it. As it stands now, however, our finances are already stretched. US investors are already glutted with government securities, so a good portion of the debt market has been going to foreigners. And the more foreign money you borrow, it seems, the more you need. In 2003, the United States had to attract $530 billion of foreign capital to finance its purchases of foreign stuff; in 2004 it had to attract $650 billion; this year, it may have to pull in as much as $800 billion. Every year of vast borrowing increases borrowing in later years; as Brad Setser of Oxford University notes, just paying interest on the $800 billion borrowed in 2005 might add $40 billion to the overall 2006 deficit.If the US Government wants to head of the dangers of a speculative run on the currency, there's only one choice: cut government borrowing. This isn't going to be possible through spending cuts alone. It's going to take higher taxes.As a theoretical matter, that is entirely untrue. There are plenty of cuts we could make. For instance, we could eliminate the Department of Education entirely. And, now that I think about it, I'm not entirely sure that the Department of Energy is strictly necessary. And, apart from doling out billions in farm subsidies to agro-conglomerates like Con-Agra, I'm not all that clear on what the Department of Agriculture does, either. Over and above that, there are all sorts of things we could do to cut spending on the non-discretionary side. Theoretically. Sadly, however, as a practical matter, I suspect the Post is right. |
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