Friday, December 16, 2005

What's Behind the Sagging Dollar?

What's Behind the Sagging Dollar?

By Scott Lilly
Many Americans are becoming aware of the fact that it is a lot tougher to go to Europe these days. It's not just that Europeans don't like our foreign policy; they don't want our currency either. Only a few years ago you could trade a dollar for one Euro and get some change to boot. Now it takes four dollars to buy only three Euros and lunch at a modest brasserie can produce a heart stopping check once the numbers are converted back from Euros.

But what few Americans understand is why this is happening. Even most elderly Americans have never lived in a world in which the dollar was not king. Living with a vulnerable currency is simply un-American and most of us are clueless as to either the cause of the dollar's weakness or its future prospects.

Since 1971 most major currencies have traded against one another based on supply and demand – much like international markets for wheat or pork bellies. The underlying factor in determining the value of a currency was trade. If the United Kingdom was buying more wine (or whatever else) from France than it was selling in wool sweaters (or whatever else) then the pound would decline against the franc. But if France had a bad year for wine and the balance of trade shifted toward the U.K. the pound would become stronger.

Value of Euro against the U.S. Dollar Since July of 2002

Like most rules in economics, there are exceptions and by far the biggest exception to the rule that the value of a nation's currency is correlated with its trade status has been the dollar. While other currencies fluctuated against each other based on trade and commerce, the dollar assumed a role as the world currency that seemed to exempt it from such fluctuation. Transactions between neighboring countries on continents as far away as Asia or Africa were often denominated in dollars and as the world economy grew the demand for dollars grew, irrespective of the underlying economic realities of U.S. trade balances.

During the same period, the U.S. demand for foreign products grew rapidly while the ability of the U.S. to produce and sell products to the rest of the world did not. If that had happened in most other countries, the value of the nation's currency would have fallen, their products would have become cheaper to the rest of the world and the cost of imports would have risen. As a result the trade deficit would have been reversed and the currency would gradually regain its value. Since the dollar has been used for more than simply financing U.S. commercial transactions, its was not substantially affected by the steadily worsening balance of trade experienced by the U.S.

As the unique capacity of the U.S. economy to absorb huge amounts of imports for an extended period of time became more apparent, some countries, such a Japan, began to develop their whole industrialization strategy around selling to the U.S. market. They could create millions of good paying jobs based on the ability of the American consumer to buy more and more products even though they weren't selling equal amounts of product back to Japan or elsewhere. In order to insure that Japanese products would be attractive to U.S. consumers, the Bank of Japan did everything in its power to keep its currency weak and the U.S. dollar artificially strong so as to lower the price of televisions, automobiles and whatever else the growing Japanese industrial giants wanted to sell on the U.S. market.

The formula for weakening the Yen and strengthening the dollar was relatively simple. The Bank of Japan would do exactly the opposite of what you would expect them to do if they were acting as prudent investors. The larger U.S. trade deficits got, the more dollars they would purchase – often buying U.S. Treasury bonds. The result was that the United States shifted from being the largest creditor nation (we owned far more assets overseas than foreigners held in U.S. stocks, bonds, real estate and other equities) to the world's largest debtor nation in the space of a decade. But it did not stop there.

Other countries saw the Japanese model and adopted it to their own plans for economic expansion. The while Korea, Taiwan, Thailand, Malaysia and Hong Kong followed that path, the most notable mimic of Japanese approach was China. As recently as 1980, China virtually had no meaningful trade relationship with the United States. This year China will sell the U.S. about $187 billion in products and buy only about $32 billion back running a bilateral trade surplus of more than $154 billion. To prevent their currency from going through the roof, the Bank of China is buying massive amounts of U.S. Treasuries and other dollar denominated assets despite the likelihood that these assets are likely to decline significantly in value. This is the price China has decided to pay in order to keep Chinese factories busy making products that can be sold on the U.S. market and to keep China's real GDP growing at close to 10% per year.

Net Asset/Debt Position of the United States 1976 to 2003

The problem is that there are already enormous sums of dollars sitting in Chinese, Korean and Japanese Banks as well as the amount needed to offset transactions around the world. At the end of last year foreigners owned about $9.6 trillion in U.S. assets and we owned about $7.2 trillion in foreign assets leaving a net foreign investment (debt) of $2.4 trillion – three times what it was only four years ago and eight times what it was only a decade ago. In absolute terms that is at least hundreds of times bigger than the net foreign debt of any country in the history of the world.

As a percentage of GDP, there are two countries, Australia and Portugal that have larger debts than the United States but the relationship between external debt and GDP does not provide the entire picture. The combined external debt of Australia and Portugal is about one four thousandth the size of the of the U.S. external debt. While the world economy could easily absorb the exports necessary to start paying down the debt of Australia and Portugal there seems little prospect of finding the more than half a trillion a year in new markets to absorb enough exports to begin to pay down the U.S. external debt.

That debt will increase significantly again this year with a trade deficit that is approaching $600 billion. Furthermore, recent studies by a variety of analysts project the continued rapid growth of the U.S. external debt for the foreseeable future.

In addition, the interest, rent or dividends that are due to foreigners who own U.S. assets ads even more to the debt. Even if U.S. assets are yielding no more than 2 or 3%, that increases the annual growth of the debt by an additional $50 to $60 billion.

So what does all of this mean?

That is a question over which there is sharp disagreement within the economics community. Some people argue that the Japanese, Chinese and others have no choice but to continue to buy dollars or their economies will be devastated. Some refer to this as "the balance of terror." Others argue that the current direction of U.S. external debt is unsustainable and that eventually the dollar will fail and might well take the global trading system down with it. Because no nation in the modern economic era has played such a dominant role in the world economy as the United States, and no nation has ever had anything like the amount of debt that the U.S. now owes, we are in totally uncharted territory.

There are, however, some disturbing precedents.

Most global depressions have been rooted in currency problems. The depression that began in Europe in the 1920s and quickly spread to the U.S. was directly tied to the fact that trade was carried out in gold and the United States had been so dominant in transatlantic trading that a huge portion of the world's gold ended up here.

Just like a monopoly game when one player ends up with all the money, the game ends. Europe's inability to buy American products meant that we had invested in far more capacity than we needed and Wall Street suddenly realized that American stocks were grossly overvalued.

Are we headed toward that type of an economic melt down?

No one knows and it probably depends a good deal on how we and other nation's handle these problems over the course of the next several years. John Williamson of the Institute of International Economics argues persuasively that the policies followed by China and Japan have not been in their own best self interest. Both countries could have used the dollars they earned from their exports to buy badly needed consumer and capital goods as well as a wide array of technical services rather than the U.S. treasury notes on which they have spent hundreds of billions of dollars and on which they will take very substantial losses under almost any scenario.

The U.S. should become much more assertive in demanding the devaluation of the China's currency. Since the Chinese won't let the dollar reach its true value against the Yuan, the dollar will fall even more dramatically against currencies that are not being manipulated and in particular, the Euro. The U.S. should also take steps to reduce the size of its federal budget deficit which tends to suck more foreign products into the country and accelerate borrowing from overseas.

Unfortunately for Americans who enjoy travel and study in Europe, the prospects for a near term reversal in the deterioration of their buying power on the Continent are not bright. Even with a considerable degree of global economic cooperation and good will, the dollar is likely to remain a very weak currency until the U.S. external debt begins to stabilize and that will affect what we pay for lots things including not only hotel rooms in Europe but oil and any other product not in abundance here in the United States.

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