Throughout the election season, I more or less ignored economics, largely because I felt both candidates were so awful in this regard that if I had focused on it too much, I might have just said to hell with it all and voted for Badnarik or not voted at all. Okay, that's a lie, I would have voted for Bush anyway. Both because economic issues were only number 2 in this election and because I have slightly more faith in the Republican party to manage the economy than I do in the Democratic party - sadly, only slightly. But I confess, a somewhat heretical thought crept into my consciousness this week. It was passing thought. But for an evening this week, I was considering the possibility that we should all be far more concerned about the long-term prospects for the U.S. economy than about terrorism.
For much of the week, I was inundated with tiny and not-so-tiny reminders about the falling dollar and the unsustainability of large government and current accounts deficits - ranging from discussions in classes to a banner greeting me as I stepped out of the Metro on Wednesday: "Bush's IQ or the dollar - which is falling faster?" (Ha. So clever, those embittered Democrats, eh?) In any case, earlier in the week, I was inspired to write a colossal post about the dollar and the long-term prospects of the U.S. economy. But by the time I actually had time to sit down at the computer and think about it, I was too exhausted to engage in such a draining and depressing activity. Alas, several days later, I still can't escape it. The forces of the universe seem to be conspiring in their insistence that I sit down and crank out a post about that which had me thinking such heretical thoughts earlier in the week. Never one to argue with the forces of the universe, I'm afraid I must comply, though this may be a little less colossal than I was planning earlier in the week.
So we all know
the dollar's falling. And it's been falling for a while. Ho-hum.
$1.3460/€, was the new low set Friday. Yawn. Unfortunately most Americans are inclined to shurg their shoulders at such news. But the falling dollar is the symptom of a deep and perennial malaise in the U.S. economy, which we've been fortunately or unfortunately spared of facing for a very long time. We've been running current account and budget deficits for so long that we don't really think they're worth worrying about anymore. Indeed, the economists who've been shrieking about this for so long are starting to look like Chicken Littles, as the catastrophe they've long predicted has yet to materialize. I've heard very intelligent people argue that economies don't work like households - where a household is limited in consumption by what it spends, economies have no such limitations.
Doesn't that sound lovely? Our government can keep spending more than it takes in and we can keep buying more than we produce for all eternity and there will never be a problem. The problem with this argument is that those who adhere to it seem to basically be arguing that for economies, money really can just grow on trees. But your mom was right: it doesn't. The money to finance our twin deficits comes from somewhere. It comes from foreigners who are willing to hold onto dollars, rather than trading them in for their own currency. As
The Economist puts it: "Imagine you could write cheques that were accepted as payment but never cashed. That is what it amounts to."
We get money to finance our personal and government consumptions only by virtue of the fact that the dollar is regarded as a safe currency to hold. Central banks, in Asia especially, hold dollars by the trillions (according to the same Economist article, the value of dollar assets held abroad is estimated at $11 trillion). So long as they're willing to continue to keep doing this, and keep buying dollars to keep its exchange rate from falling too sharply, we can keep spending to our hearts' delights. But the longer we do so, the more skeptical they become of us. Fundamentally, a country is exactly like a household or a company, in spite of what some claim. It works on a
much larger scale, yes. But think about it. You, as an individual, can actually spend more than you take in, by virtue of consumer debt. However, the more debt you take on, the more skeptical banks become of your ability to repay it. Financial markets, both for consumers and for countries, are entirely subjective. As long as lendors
believe you can repay your debts and investors believe you're worth the price, they'll continue to give you money. As soon as they believe otherwise, say good-bye to fast money.
The fact that foreigners have been willing to finance our consumption for as long as they have is rather astounding when you think about it. It is testament only to the fact of the extraordinary power of the U.S. economy over recent decades. Signs are that this willingness is coming to an end.
Says Bloomberg:
The dollar may decline to $1.57 per euro and 87 yen before it finds a ``long-term bottom,'' according to a study by Goldman Sachs Group Inc.
``It seems very hard to believe that the dollar is close to the end of its decline,'' judged by a history of currency crises in other countries, wrote Alberto Ades, director of global markets research, and Jens Nordvig, a market economist at Goldman in New York. Goldman studied 26 emerging-market currency crises between 1985 and 1999 to estimate how low the dollar may drop to help narrow its record current-account deficit.
Yellen helped send the dollar down almost 1 percent on Sept. 10, when she said the deficit will widen unless the dollar falls.
Overseas investors may curb their financing of the U.S. deficit, Fed Chairman Alan Greenspan said at the European Banking Congress in Frankfurt on Nov. 19. ``A diminished appetite for adding to dollar balances must occur at some point,'' he said.
Fed officials' comments ``reinforce the widespread assumption the Fed thinks a weaker dollar is likely and probably beneficial,'' said Sean Callow, a currency strategist at IDEAglobal in New York.
And CNN:
Reports showing accelerating U.S. factory growth in November and a strong start to consumer spending in the fourth-quarter did nothing to stem the dollar's slide, despite bolstering expectations for the Federal Reserve to keep lifting official rates.
By comparison, European data showed manufacturing growth stalled last month and new orders for goods contracting for the first time in more than a year, with some economists blaming the dollar's gains on the dent to exports.
"Nobody seems to care about the economic data," said Marshall Gittler, senior currency strategist at Deutsche Bank in Tokyo. "That indicators' sentiment for the dollar is seriously, seriously bearish."
Even a 1.5 percent jump in the S&P 500 Monday to a new three-year high offered no solace for the dollar.
The dollar has fallen by a 35% against the euro and 24% against the yen over the past 3 years. That 's a pretty big drop. Fortunately for all of us, and I do mean all of us, it has been a gradual drop. A weak dollar (negative as such a thing sounds) is the only way to correct our current account deficit. If it drops slowly, hopefully, things can stay in relative equilibrium and not cause massive chaos and recessions or depressions worldwide.
In spite of this, the idea of a weak dollar doesn't sell very well in Europe or Asia.
Japan and the eurozone authorities have discussed the prospect of joint currency market intervention if the yen and euro continue to strengthen against the dollar, a senior Japanese finance ministry official said on Wednesday.
[...]
The official, speaking to reporters on condition of anonymity, added that recent comments about the US current account deficit by Alan Greenspan, chairman of the US Federal Reserve, were a “misjudgment” that had increased market volatility.
[...]
The ministry official said the dollar should not be weakening given the superior US growth performance. “If there is a general depreciation in the dollar, we should have harmonised action,” he said. “If the [dollar's] movement affects the European economy and the Japanese economy, we should defend ourselves.”
I side with the Fed on this. While I appreciate the European and Japanese concerns, that the weakening dollar hurts their exports to the U.S., the fundamentals of the U.S. economy suggest that the dollar should be weak.
Eventually, the dollar is going to fall. If it does so relatively slowly, it might be relatively painless. If, on the other hand, foreigners continue to artificially prop it up by buying dollars, it will eventually experience a precipitous crash that we will all
deeply regret. Indeed,
The Economist, which seems to agree with me on the need for the dollar to fall,
is far less sanguine than I am about the possibility of it to fall painlessly:
America has habits that are inappropriate, to say the least, for the guardian of the world's main reserve currency: rampant government borrowing, furious consumer spending and a current-account deficit big enough to have bankrupted any other country some time ago. This makes a dollar devaluation inevitable, not least because it becomes a seemingly attractive option for the leaders of a heavily indebted America. Policymakers now seem to be talking the dollar down. Yet this is a dangerous game. Why would anybody want to invest in a currency that will almost certainly depreciate?
[...]
America's current-account deficit is at the heart of these global concerns. The OECD's latest Economic Outlook predicts that the deficit will rise to $825 billion by 2006 (6.4% of America's GDP) assuming unchanged exchange rates. Optimists argue that foreigners will keep financing the deficit because American assets offer high returns and a haven from risk. In fact, private investors have already turned away from dollar assets: the returns on investments in America have recently been lower than in Europe or Japan (see article). And can a currency that has been sliding against the world's next two biggest currencies for 30 years be regarded as “safe”?
In a free market, without the massive support of Asian central banks, the dollar would be far weaker. In any case, such support has its limits, and the dollar now seems likely to fall further. How harmful will the economic consequences be? Will it really undermine the dollar's reserve-currency status?
Periods of dollar decline have often been unhappy for the world economy. The breakdown of Bretton Woods that led to a weaker dollar in the early 1970s was painful for all, contributing to rising inflation and recession. In the late 1980s, the falling dollar had few ill-effects on America's economy, but it played a big role in inflating a bubble in Japan by forcing Japanese authorities to slash interest rates.
[...]
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.
The dollar's loss of reserve-currency status would lead America's creditors to start cashing those cheques—and what an awful lot of cheques there are to cash. As that process gathered pace, the dollar could tumble further and further. American bond yields (long-term interest rates) would soar, quite likely causing a deep recession. Americans who favour a weak dollar should be careful what they wish for. Cutting the budget deficit looks cheap at the price.
The problem with their analysis is that I'm not exactly sure what they think we should to do about it, absent a fall in the dollar. Yes, clearly, the budget deficit is a part of the problem, and that's something that Congress ought to deal with, but shows no signs of caring about. But fixing the budget deficit alone will not correct the current account deficit. The current account is a product of decentralized American consumer preferences, not the organized effort or negligence of some centralized authority. How does one fix that, besides by making imports more expensive, i.e., by letting the dollar fall?
This is a looming crisis that has been gathering for years. If the dollar gets propped up by foreign banks again, and the U.S. economy continues to look healthy by other indicators, we will probably all continue with the happy delusion of the strong U.S. economy. But eventually the illusions will come crashing down, and the longer we preserve them, the worse the crisis will be when it finally comes. And the disruption in the world economy were the U.S. economy to crash would be absolutely devastating, to the point that I hate to even think about it.
I started this post by confessing that I was briefly entertaining the thought that the economy could be a worse threat to us than terrorism. I say this, not because I've come to the conclusion that terrorism isn't really a threat, but because past periods of economic turmoil have led to, well, massive wars. Should the dollar and subsequently the U.S. economy crash in a really brutal way, which I believe could happen, the worldwide economic order could come completely unglued. And with it, the relatively peaceful political order that much of the world has built since our last truly catastrophic war.
Go ahead, discuss.
