Save the Day
September 25, 2007
Currencies are first and foremost relative prices in essence, they are measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years. The dollar, relative to the currencies of most of America's trading partners, had fallen by about 20 percent from its early 2002 peak. Recently it has hit new lows against the euro and a high-flying Canadian currency, likely a harbinger of more weakness to come.
Sadly, none of this is surprising. Because Americans haven't been saving in sufficient amounts, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit the broadest gauge of America's imbalance in relation to the rest of the world hit a record 6.2 percent of GDP in 2006 before the pressures of the business cycle triggered a temporary reduction in 2008. Even so, savings-short America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing.
Economic science is very clear on the implications of such huge imbalances: Foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the compensation. The currency of the deficit nation usually bears the brunt of that compensation. As long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will eventually resume its decline.
The only silver lining so far has been that these adjustments to the currency have been orderly declines in the broad dollar index averaging a little less than 4 percent per year since early 2002. Now, however, the possibility of a disorderly correction is rising with potentially grave consequences for the American and global economy.
A key reason is the mounting risk of a recession in America. The bursting of the subprime mortgage bubble strikingly reminiscent of the dot-com excesses of the 1990scould well be a tipping point. In both cases, financial markets and policy makers were steeped in denial over the risks. But the lessons of postbubble adjustments are clear. Just ask economically stagnant Japan. And of course, the United States lapsed into its own postbubble recession in 2000 and 2001.
Sadly, the endgame could be considerably more treacherous for the United States than it was seven years ago. In large part, that's because the American consumer is now at risk. In early 2007, consumption expenditures peaked at a record 72 percent of the GDP a number unmatched in the annals of modern history for any nation.
This buying binge has been increasingly supported by housing and lending bubbles. Yet home prices are now headed lower probably for years and the fallout from the subprime crisis has seriously crimped home mortgage refinancing. With weaker employment growth also putting pressure on income, the days of open-ended American consumption are finally coming to an end. This makes it all but impossible to avoid a recession.
Fearful of that outcome, foreign investors are becoming increasingly skittish over buying dollar-based assets. The spillover effects of the subprime crisis into other asset markets especially mortgage-backed securities and asset-backed commercial paper underscore these concerns.
Foreign appetite for U. S. financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar.
The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour . New legislation is likely, which would impose trade sanctions on China unless China makes a major adjustment in its currency. Not only would this be an egregious policy blunder attempting to fix a multilateral deficit with nearly 100 nations by forcing an exchange rate adjustment with one country but it would also amount to Washington taxing one of America's major foreign lenders.
That would undoubtedly reduce China's desire for U. S. assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure. Moreover, the more the Fed under Ben Bernanke follows the easy-money Alan Greenspan script, the greater the risk to the dollar.
Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: No nation has ever devalued its way into prosperity.
So far, the dollar's weakness has not been a big deal. That may now be about to change. Relative to the rest of the world, the United States looks painfully subprime. So does its currency.
From Stephen Roach on the Next Asia: Opportunities and Challenges for a New Globalization by Stephen Roach. Copyright 2009 by Stephen Roach. Published by Wiley. Used by permission of the publisher. All rights reserved.
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