Dollar falls

The disappearing dollar

Dec 2nd 2004
From The Economist print edition

How long can it remain the world's most important reserve currency?

THE dollar has been the leading international currency for as long as most people can remember. But its dominant role can no longer be taken for granted. If America keeps on spending and borrowing at its present pace, the dollar will eventually lose its mighty status in international finance. And that would hurt: 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 (for Chinese TV’s, Japanese cars, etc) that were accepted as payment by other countries 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. Bush-America is taking no such care, and may come to regret it.

The cost of neglect

The dollar is not what it used to be. Over the past three years it has fallen by 35% against the euro and by 24% against the yen. But its latest slide is merely a symptom. Bush-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.

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 – which educate all their children. Can a currency that has been sliding against the world's next two biggest currencies for 30 years be regarded as “safe”? Most of the blame for America's deficit lies at home. America needs to cut its budget deficit.

Simple but harsh

Many Bush administration policymakers talk as though it is better to rely entirely on a falling dollar to solve, somehow, all their problems. Such a one-sided remedy would require existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion - as a fall in the dollar by another 30% wipes $3 or $4 trillions off the value of foreigners' dollar assets. OPEC (Organisation of Petroleum Exporting Countries) has already cut the proportion of deposits held in dollars from 75 per cent in the third quarter of 2001 to 61.5 per cent now, to avoid incurring losses as the dollar has fallen and prepare for a shift away from pricing oil exports in dollars alone.

If foreigners do not subsidize the Bush scam, the dollar will lose its reserve-currency status. That 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. Cutting the budget deficit would require political courage now. Why not leave the time-bomb for the non-voting kids?

Warning From the Markets

Published: February 24, 2005 en a seemingly innocuous remark from the central bank of South Korea makes the dollar tank, as happened on Tuesday, all is not well with the United States' position in the world economy.

The dollar has been on a downward trajectory for three years, thanks in part to the Bush administration's decision to try to use a cheap dollar to shrink the nation's enormous trade deficit. (A weak dollar makes exports cheaper and imports costlier, a combination that theoretically should narrow the trade gap.) To be truly effective, however, a weak dollar must be combined with a lower federal budget deficit - or even a budget surplus, something the administration clearly hasn't delivered. So predictably, the weak-dollar ploy hasn't worked. The United States' trade deficit has mushroomed to record levels, as has the United States' need to borrow from abroad - some $2 billion a day - just to balance its books.

Enter South Korea. On Monday, its central bank reported that it intended to diversify into other currencies and away from dollar-based assets. And why not? It holds about $69 billion in United States Treasury securities, or 4 percent of the total foreign Treasury holdings. Such dollar-based investments lose value as the dollar weakens, leading to losses that any cautious banker would want to avoid. But as the Korean comment ping-ponged around the world, all hell broke loose, with currency traders selling dollars for fear that the central banks of Japan and China, which hold immense dollar reserves - a combined $900 billion, or 46 percent of foreign Treasury holdings - might follow suit.

That would be the United States' worst economic nightmare. If it appeared that the flow of investment from abroad was not enough to cover the nation's gargantuan deficits, interest rates would rise sharply, the dollar would plunge further, and the economy would stall. A fiscal crisis would result.

Tuesday's sell-off of dollars did not precipitate a meltdown. But it sure gave a taste of one. The dollar suffered its worst single-day decline in two months against the yen and the euro. Stock markets in New York, London, Paris and Frankfurt dropped, and gold and oil prices, which tend to go up when the dollar goes down, spiked.

Luckily, the markets calmed down yesterday, as Asian central banks said they they did not intend to shun dollars. While such damage control is welcome, it's no fix. Tuesday's market episode has its roots in American structural imbalances that will be corrected only by new policies, not more of the same tax-cut-and-weak-dollar deficit-bloating ploys.

If Mr. Bush were half the capitalist he claims he is, he would listen to what the markets are telling him.

Honey, I Shrunk the Dollar

By THOMAS L. FRIEDMAN

Published: February 24, 2005

have just one question about President Bush's trip to Europe: Did he and Laura go shopping?

If they did, I would love to have been a fly on the wall when Laura must have said to George: "George, do you remember how much these Belgian chocolates cost when we were here four years ago? This box of mints was $10. Now it's $15? What happened to the dollar, George? Why is the euro worth so much more now, honey? Didn't Rummy say Europe was old? If we didn't have Air Force One, we never could have afforded this trip on your salary!"

The dollar is falling! The dollar is falling! But the Bush team has basically told the world that unless the markets make the falling dollar into a full-blown New York Stock Exchange crisis and trade war, it is not going to raise taxes, cut spending or reduce oil consumption in ways that could really shrink our budget and trade deficits and reverse the dollar's slide.

This administration is content to let the dollar fall and bet that the global markets will glide the greenback lower in an "orderly" manner.

Right. Ever talk to someone who trades currencies? "Orderly" is not always in the playbook. I make no predictions, but this could start to get very "disorderly." As a former Clinton Commerce Department official, David Rothkopf, notes, despite all the talk about Social Security, many Americans are not really depending on it alone for their retirement. What many Americans are counting on is having their homes retain and increase their value. And what's been fueling the home-building boom and bubble has been low interest rates for a long time. If you see a continuing slide of the dollar - some analysts believe it needs to fall another 20 percent before it stabilizes - you could see a substantial, and painful, rise in interest rates.

"Given the number of people who have refinanced their homes with floating-rate mortgages, the falling dollar is a kind of sword of Damocles, getting closer and closer to their heads," Mr. Rothkopf said. "And with any kind of sudden market disruption - caused by anything from a terror attack to signs that a big country has gotten queasy about buying dollars - the bubble could burst in a very unpleasant way."

Why is that sword getting closer? Because global markets are realizing that we have two major vulnerabilities that this administration doesn't want to address: We are importing too much oil, so the dollar's strength is being sapped as oil prices continue to rise. And we are importing too much capital, because we are saving too little and spending too much, as both a society and a government.

"When people ask what we are doing about these twin vulnerabilities, they have a hard time coming up with an answer," noted Robert Hormats, the vice chairman of Goldman Sachs International. "There is no energy policy and no real effort to reduce our voracious demand of foreign capital. The U.S. pulled in 80 percent of total world savings last year [largely to finance our consumption]." That's a big reason why some "43 percent of all U.S. Treasury bills, notes and bonds are now held by foreigners," Mr. Hormats said.

And the foreign holders of all those bonds are listening to our debate. They are listening to a country that is refusing to raise taxes, and an administration talking about borrowing an additional $2 trillion so Americans can invest some of their Social Security money in stocks. If that happened, it would almost certainly weaken the dollar, further depreciating the U.S. Treasury bonds held by all those foreigners.

On Monday, the Bank of Korea said it planned to diversify more of its reserves into nondollar assets, after years of holding too many low-yielding and depreciating U.S. government securities. The fear that this could become a trend sparked a major sell-off in U.S. equity markets on Tuesday. To calm the markets, the Koreans said the next day that they had no intention of selling their dollars.

Oh, good. Now I'm relieved.

"These countries don't have to dump dollars - they just have to reduce their purchases of them for the dollar to be severely affected," Mr. Hormats noted. "Korea is the fourth-largest holder of dollar reserves. ... You don't want others to see them diversifying and say, 'We'd better do that, too, so that we're not the last ones out.' Remember, the October 1987 stock market crash began with a currency crisis."

When a country lives on borrowed time, borrowed money and borrowed energy, it is just begging the markets to discipline it in their own way at their own time. As I said, usually the markets do it in an orderly way - except when they don't.