Dollar Anxiety

Real Reasons to Worry: The advantages of imperial finance have propped up the U.S. economy--but they may not last.


This article is from the January/February 2005 issue of Dollars and Sense: The Magazine of Economic Justice available at

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This article is from the January/February 2005 issue of Dollars & Sense magazine.

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The value of the dollar is falling. Does that mean that our economic sky is falling as well? Not to sound like Chicken Little, but the answer may well be yes. If an economic collapse is not in our future, then at least economic storm clouds are gathering on the horizon.

It's what lies behind the slide of the dollar that has even many mainstream economists spooked: an unprecedented current account deficit--the difference between the country's income and its consumption and investment spending. The current account deficit, which primarily reflects the huge gap between the amount the United States imports and the amount it exports, is the best indicator of where the country stands in its financial relationship with the rest of the world.

At an estimated $670 billion, or 5.7% of gross domestic product (GDP), the 2004 current account deficit is the largest ever. An already huge trade deficit (the amount exports fall short of imports) made worse by high oil prices, along with rock bottom private savings and a gaping federal budget deficit, have helped push the U.S. current account deficit into uncharted territory. The last time it was above 4% of GDP was in 1816, and no other country has ever run a current account deficit that equals nearly 1% of the world's GDP. If current trends continue, the gap could reach 7.8% of U.S. GDP by 2008, according to Nouriel Roubini of New York University and Brad Setser of University College, Oxford, two well-known finance economists.

Most of the current account deficit stems from the U.S. trade deficit (about $610 billion). The rest reflects the remittances immigrants send home to their families plus U.S. foreign aid (together another $80 billion) less net investment income (a positive $20 billion because the United States still earns more from investments abroad than it pays out in interest on its borrowing from abroad).

The current account deficit represents the amount of money the United States must attract from abroad each year. Money comes from overseas in two ways: foreign investors can buy stock in U.S. corporations, or they can lend money to corporations or to the government by buying bonds. Currently, almost all of the money must come from loans because European and Japanese investors are no longer buying U.S. stocks. U.S. equity returns have been trivial since 2000 in dollar terms and actually negative in euro terms since the dollar has lost ground against the euro.

In essence, the U.S. economy racks up record current account deficits by spending more than its national income to feed its appetite for imports that are now half again exports. That increases the supply of dollars in foreign hands.

At the same time, the demand for dollars has diminished. Foreign investors are less interested in purchasing dollar-dominated assets as they hold more of them (and as the self-fulfilling expectation that the value of the dollar is likely to fall sets in). In October 2004 (the most recent data available), net foreign purchases of U.S. securities--stocks and bonds--dipped to their lowest level in a year and below what was necessary to offset the current account deficit. In addition, global investors' stock and bond portfolios are now overloaded with dollar-denominated assets, up to 50% from 30% in the early ‘90s.

Under the weight of the massive current account deficit, the dollar has already begun to give way. Since January 2002, the value of the dollar has fallen more than 20%, with much of that dropoff happening since August 2004. The greenback now stands at multiyear lows against the euro, the yen, and an index of major currencies.

Should foreign investors stop buying U.S. securities, then the dollar will crash, stock values plummet, and an economic downturn surely follow. But even if foreigners continue to purchase U.S. bonds--and they already hold 47% of U.S Treasury bonds--a current account deficit of this magnitude will be a costly drag on the economy. The Fed will have to boost interest rates, which determine the rate of return on U.S. bonds, to compensate for their lost value as the dollar slips in value and to keep foreigners coming back for more. In addition, a falling dollar makes imports cost more, pushing up U.S inflation rates. The Fed will either tolerate the uptick in inflation or attempt to counteract it by raising interest rates yet higher. Even in this more orderly scenario of decline, the current expansion will slow or perhaps come to a halt.

Imperial Finance

You can still find those who claim none of this is a problem. Recently, for example, the editors of the Wall Street Journal offered worried readers the following relaxation technique--a version of what former Treasury Secretary Larry Summers says is the sharpest argument you typically hear from a finance minister whose country is saddled with a large current account deficit.

First, recall that a large trade deficit requires a large surplus of capital flowing into your country to cover it. Then ask yourself, would you rather live in a country that continues to attract investment, or one that capital is trying to get out of? Finally, remind yourself that the monetary authorities control the value of currencies and are fully capable of halting the decline.

If the United States Were an Emerging Market

If the United States were a small or less-developed country, financial alarm bells would already be ringing. The U.S. current account deficit is well above the 5%-of-GDP standard the IMF and others use to pronounce economies in the developing world vulnerable to financial crisis.

Just how crisis-prone depends on how the current account deficit affects the economy's spending. If the foreign funds flowing into the country are being invested in export-producing sectors of the economy, or the tradable goods sectors, such as manufacturing and some services, they are likely over time to generate revenues necessary to pay back the rest of the world. In that case, the shortfall is less of a problem. If those monies go to consumption or speculative investment in non-tradable (i.e., non-export producing) sectors such as a real estate, then they surely will be a problem.

By that standard, the U.S. current account deficit is highly problematic. Economists assess the impact of a current account deficit by comparing it to the difference between net national investment and net national savings. (Net here means less the money set aside to cover depreciation.) In the U.S. case, that difference has widened because saving has plummeted, not because investment has picked up. Last year, the United States registered its lowest net national savings rate ever, 1.5%, due to the return of large federal budget deficits and anemic personal savings. In addition, U.S. investment has shifted substantially away from tradable goods as manufacturing has come under heavy foreign competition toward the non-traded goods sector, such as residential real estate whose prices have soared in and around most major American cities.

Capital inflows that cover a decline in savings instead of a surge in investment are not a sign of economic health nor cause to stop worrying about the current account deficit.

Feel better? You shouldn't. Arguments like these are unconvincing, a bravado borne not of postmodern cool so much as the old-fashioned, unilateral financial imperialism that underlies the muscular U.S. foreign policy we see today.

True, so far foreigners have been happy to purchase the gobs of debt issued by the U.S. Treasury and corporate America to cover the current account deficit. And that has kept U.S. interest rates low. If not for the flood of foreign money, Morgan Stanley economist Stephen Roach figures, U.S. long-term interest rates would be between one and 1.5 percentage points higher today.

The ability to borrow without pushing up interest rates has paid off handsomely for the Bush administration. Now when the government spends more than it takes in to prosecute the war in Iraq and bestow tax cuts on the rich, savers from foreign shores finance those deficits at reduced rates. And cash-strapped U.S. consumers are more ready to swallow an upside-down economic recovery that has pushed up profit but neither created jobs nor lifted wages when they can borrow at low interest rates.

How can the United States get away with running up debt at low rates? Are other countries' central banks and private savers really the co-dependent "global enablers" Roach and others call them, who happily hold loads of low-yielding U.S. assets? The truth is, the United States has taken advantage of the status of the dollar as the currency of the global economy to make others adjust to its spending patterns. Foreign central banks hold their reserves in dollars, and countries are billed in dollars for their oil imports, which requires them to buy dollars. That sustains the demand for the dollar and protects its value even as the current account imbalance widens.

The U.S. strong dollar policy in the face of its yawning current account deficit imposes a "shadow tax" on the rest of the world, at least in part to pay for its cost of empire. "But payment," as Robert Skidelsky, the British biographer of Keynes, reminds us, "is voluntary and depends at minimum on acquiescence in U.S. foreign policy." The geopolitical reason for the rest of the capitalist world to accept the "seignorage of the dollar"--in other words, the advantage the United States enjoys by virtue of minting the reserve currency of the international economy--became less compelling when the United States substituted a "puny war on terrorism" for the Cold War, Skidelsky adds.

The tax does not fall only on other industrialized countries. The U.S. economy has not just become a giant vacuum cleaner that sucks up "all the world's spare investible cash," in the words of University of California, Berkeley economist Brad DeLong, but about one-third of that money comes from the developing world. To put this contribution in perspective: DeLong calculates that $90 billion a year, or one-third of the average U.S. current account deficit over the last two decades, is equal to the income of the poorest 500 million people in India.

The rest of the world ought not to complain about these global imbalances, insist the strong dollar types. That the United States racks up debt while other countries rack up savings is not profligacy but a virtue. The United States, they argue, is the global economy's "consumer of last resort." Others, especially in Europe, according to U.S. policymakers, are guilty of "insufficient consumption": they hold back their economies and dampen the demand for U.S. exports, exacerbating the U.S. current account deficit. Last year U.S. consumers increased their spending three times as quickly as European consumers (excluding Britain), and the U.S. economy grew about two and half times as quickly.

Global Uprising

Not surprisingly, old Europe and newly industrializing Asia don't see it that way. They have grown weary from all their heavy lifting of U.S. securities. And while they have yet to throw them overboard, a revolt is brewing.

Those cranky French are especially indignant about the unfairness of it all. The editors of Le Monde, the French daily, complain that "The United States considers itself innocent: it refuses to admit that it lives beyond its means through weak savings and excessive consumption." On top of that, the drop of the dollar has led to a brutal rise in the value of the euro that is wiping out the demand for euro-zone exports and slowing their already sluggish economic recoveries.

Even in Blair's Britain the Economist, the newsweekly, ran an unusually tough-minded editorial warning: "The dollar's role as the leading international currency can no longer be taken for granted. … Imagine if you could write checks that were accepted as payment but never cashed. That is what [the privileged position of the dollar] amounts to. If you had been granted that ability, you might take care to hang to it. America is taking no such care. And may come to regret it."

But the real threat comes from Asia, especially Japan and China, the two largest holders of U.S. Treasury bonds. Asian central banks already hold most of their reserves in dollar-denominated assets, an enormous financial risk given that the value of the dollar will likely continue to fall at current low interest rates.

In late November, just the rumor that China's Central Bank threatened to reduce its purchases of U.S. Treasury bonds was enough to send the dollar tumbling.

No less than Alan Greenspan, chair of the Fed, seems to have come down with a case of dollar anxiety. In his November remarks to the European Banking Community, Green­span warned of a "diminished appetite for adding to dollar balances" even if the current account deficit stops increasing. Greenspan believes that foreign investors are likely to realize they have put too many of their eggs in the dollar basket and will either unload their dollar-denominated investments or demand higher interest rates. After Greenspan spoke, the dollar fell to its lowest level against the Japanese yen in more than four years.

A Rough Ride From Here

The question that divides economists at this point is not whether the dollar will decline more, but whether the descent will be slow and orderly or quick and panicky. Either way, there is real reason to believe it will be a rough ride.

First, a controlled devaluation of the dollar won't be easy to accomplish. Several major Asian currencies are formally or informally pegged to the dollar, including the Chinese yuan. The United States faces a $160 billion trade deficit with China alone. U.S. financial authorities have exerted tremendous pressure on the Chinese to raise the value of their currency, in the hope of slowing the tide of Chinese imports into the United States and making U.S. exports more competitive. But the Chinese have yet to budge.

Beyond that, a fall in the dollar sufficient to close the current account deficit will slaughter large amounts of capital. The Economist warns that "[i]f 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."

Even a gradual decline in the value of dollar will bring tough economic consequences. Inflation will pick up, as imports cost more in this bid to make U.S. exports cheaper. The Fed will surely raise interest rates to counteract that inflationary pressure, slowing consumer borrowing and investment. Also, closing the current account deficit would require smaller government deficits. (Although not politically likely, repealing Bush's pro-rich tax cuts would help.)

What will happen is anyone's guess given the unprecedented size of the U.S. current account deficit. But there is a real possibility that the dollar's slide will be anything but slow or orderly. Should Asian central banks stop intervening on the scale needed to finance the U.S. deficit, then a crisis surely would follow. The dollar would drop through the floor; U.S. interest rates would skyrocket (on everything from Treasury bonds to mortgages to credit cards); the stock market and home values would collapse; consumer and investment spending would plunge; and a sharp recession would take hold here and abroad.

The Bush administration seems determined to make things worse. Should the Bush crew push through their plan to privatize Social Security and pay the trillion-dollar transition cost with massive borrowing, the consequences could be disastrous. The example of Argentina is instructive. Privatizing the country's retirement program, as economist Paul Krugman has pointed out, was a major source of the debt that brought on Argentina's crisis in 2001. Dismantling the U.S. welfare state's most successful program just might push the dollar-based financial system over the edge.

The U.S. economy is in a precarious situation held together so far by imperial privilege. Its prospects appear to fall into one of three categories: a dollar crisis; a long, slow, excruciating decline in value of the dollar; or a dollar propped up through repeated interest rates hikes. That's real reason to worry.

John Miller teaches economics at Wheaton College and is a member of the Dollars & Sense collective.

RESOURCES   "Dollar Anxiety," editorial, Wall Street Journal, 11/11/04; D. Wessel, "Behind Big Drop in Currency: U.S. Soaks Up Asia's Output," WSJ, 12/2/04; J. B. DeLong, "Should We Still Support Untrammeled International Capital Mobility? Or are Capital Controls Less Evil than We Once Believed," Economists' Voice, 2004; R. Skidelsky, "U.S. Current Account Deficit and Future of the World Monetary System" and N. Roubini and B. Setser "The U.S. as A Net Debtor: The Sustainability of the U.S. External Imbalances," 11/04, Nouriel Roubini's Global Macroeconomic and Financial Policy site <>; Rich Miller, "Why the Dollar is Giving Way," Business Week, 12/6/04; Robert Barro, "Mysteries of the Gaping Current-Account Gap," Business Week, 12/13/04; D. Streitford and J. Fleishman, "Greenspan Issues Warning on Dollar," L.A. Times, 11/20/04; S. Roach, "Global: What Happens If the Dollar Does Not Fall?" Global Economic Forum, Morgan Stanley, 11/22/04; L. Summers, "The U.S. Current Account Deficit and the Global Economy," The 2004 Per Jacobsson Lecture, 10/3/04; "The Dollar," editorial, The Economist, 12/3/04; "Mr. Gaymard and the Dollar," editorial, Le Monde, 11/30/04.