Scary Bedtime Stories
Amid the news from financial markets today that the dollar had fallen to a new low versus the euro–breaking a previous record only a week old(as reported in the Wall Street Journal and displayed succinctly in this graph)–I thought I’d relate why I’m having trouble sleeping nights.
I had nightmares yesterday because I fell asleep after reading The Economist’s Finance and Economics section, the last article in which was “Checking the depth gauge: How far might the dollar sink?” (subscription req’d)
The answer, Economist’s economics writer suggests, is pretty far–perhaps 20% to 40% more than it’s already fallen.
The Economist article relies heavily on this National Bureau of Economic Research paper by Maurice Obstfeld and Kenneth Rogoff (link here); in passing, I’ll note here that while visiting the offices of a professional economist this afternoon, one of the books on his desk was the Obstfeld-Rogoff textbook on international monetary flows. Obstfeld and Rogoff argue that not only is the current U.S. trade deficit unsustainable, the dollar overvalued, and the global financial system at risk from those two factors, the dollar is likely to collapse, not gradually deflate.
O. and R., and just about every economist I’ve read on this issue (and I’ve been keeping particular tabs on this, for reasons I explain below), point out that a major factor in the vulnerability to the dollar is the virtual collapse of American net domestic saving. Brad DeLong has a graph that shows this in some detail; former Treasury Secretary and current Harvard President Larry Summers has a surprisingly readable brief overview of the savings gap. Summers states that the net national savings for the U.S. has been between 1 and 2 percent of NNP (net national product), its lowest level in American history.
To simplify matters (and probably oversimplify a bit): Households and corporations save, and through financial intermediaries, this saving is converted into investment. But when the government runs deficits, it funds those deficits through the same market for debt as used by corporations seeking private investment. Thus, when, as now, government demand for debt skyrockets, private investors (whose demand is necessarily more elastic than that of the government) are crowded out of the market.
Complicating the issue is the lack of American household savings. If the money to fund American government spending isn’t coming from U.S. households, then where is it coming from? The answer is simple: Asia. “It is eating up around 75% of the excess saving of Japan, China, Germany and other countries with current-account surpluses,” Economist writes. Most of this debt, Summers says, is held by Asian central banks. These are big holdings: Taiwan’s reserves exceed those of all Latin America. As the Economist notes, if the dollar wasn’t the basis for global finance, the country would already be in serious trouble.
The issue gets even more complicated.
China and other Asian countries have pegged their currencies to the dollar in order to make their exports more competitive. To support that policy, their central banks have been, as noted above, buying up billions of dollars. As this Wall Street Journal article notes, though, eventually reality will kick in, as it already has for Chinese consumers who are rushing to dump the dollar in favor of yen or euro (or, heck, even RMB, which you can’t even take out of the country). Central banks won’t be immune to similar pressures forever: Falls in the dollar’s value are automatically charges against their balance sheets.
Ultimately, however, the nature of Asian currency pegs (and really that means China) makes this a political issue more than an economic one. The Washington Post reports today that Bush will raise China’s peg with President Hu Jintao at a summit in Chile, asking Beijing to revalue the yuan against the dollar so that Chinese exports become more expensive, allowing the trade deficit to subside.
At this point, I should note the administration’s official position, as reported in this New York Times piece: That the current-account deficit reflects America’s strengths, not its weakness. This is laughable, and if you read Obstfeld and Rogoff, The Economist, the Wall Street Journal, Summers, et al, you will hear polite (or scornful) academic laughter. On the other hand, what’s the administration supposed to do? Cut deficits and negotiate a managed devaluation, yes–but in the meantime they’ve got to keep up a good front. (Treasury Secretary John Snow and the rest of the administration, though, have ruled out any managed devaluation. In fact, according to this Financial Times article, he’s blaming the slow growth of Europe’s economies for the dollar’s troubles. Which may be true, but doesn’t help.)
So here’s the situation: Strong American growth and weak European and Japanese growth led to a situation where the U.S. had widening trade deficits, a position exacerbated by the U.S. government’s sudden switch from surplus to multi-hundred-billion-dollar deficits. The dollar is now dependent upon Asian lenders (and other financial players) for its strength, which means that a large part of U.S. dollar policy is being made by Beijing. The Treasury says there’s no plans afoot to manage the dollar’s devaluation.
Here’s the final complication: O. and R. contend, however, that a change in the dollar’s valuation will not, by itself, resolve the U.S.’s economic problem. What is needed is productivity gains in nontradeable goods (i.e., services) and a sudden jump in saving. They do say, however, that the revaluation of the dollar need not be painful: In the 80s, the dollar was revalued vis-a-vis the other major world currencies more or less painlessly. But O. and R. say that it’s more likely that the drop in the dollar’s value will hurt.
So why is this keeping me up at night? Because I live in Europe, but my savings live in the United States. Assuming that I have a thousand dollars in my savings bank [insert simultaneously dry, yet wistful laugh], a 20% to 40% devaluation in the dollar will cost me hundreds of euro. To a graduate student, such a massive shock is troubling. It is, in fact, the stuff of nightmares.
Sorry to be nitpicky, but China’s currency is either RMB or yuan; never yen.
Yes, and it’s measured in kuai. Changes to be made momentarily; thanks for catching it.
Hey Paul, you forgot to mention this little tidbit, a couple of weeks ago, new Fed issues hit the street up here. Typically Asian buyers scoop these up in a hurry. This latest round though? All quiet on the eastern front. Gotta buddy a BofA saying he’s never seen anything like it in 25 years of trading. Hiss… goes the bubble.
If the government really cared about savings, it would not double tax the money. Yes, there is not encouragement to save for a variety of reasons. For me, by the time I put my money in a bank with its pidly interest rate, I have lost money. Also, any interest earned is taxed.
I live in Europe too. I came here in Janruary 2003 and the first thing I did was take out 500 euro a day at the ATMs here and put my money in a bank here. It was a good move as the euro has gone up like 25 cents on the dollar since then. You should get your money out of the states now if you are going to be living here for any length of time.
Well that
Paul,
Good summary, in my mind the fall in the value of the dollar is almost a sure thing over the next few years.
Unfortunately most Americans don’t understand exactly how it affects them, but it does. Biggest example; high gas prices, since oil is quoted in dollars, when the value of the dollar drops, the price of oil goes up.
Fortunately there are easy things Americans can do to protect themselves from some of the effects of the dollar drop, for example invest in non-dollar denominated assets as well as gold and natural resources. Unfortunately most of the people Americans turn to for investment advice neglect to explain how important that is.
-Tim
Very good points and one that fiscally-conservative liberals (like me!) have been saying for some time.
You omitted three very important issues, one touched on by a responder, and that is oil. interest (rates), and social security.
As for the first, oil is currently priced in dollars which has two effects. First, it causes a lot of countries (like China, until recently) to hold a lot of dollars so that they can use those dollars to buy oil. They get those dollars, effectively, by lending the US treasury money — i.e. taking an investment position in the dollar.
China is dumping its dollar holdings for two reasons. First, it’s losing confidence in the dollar long-term and, second, it no longer wishes to finance a nation with which it will very soon come into direct competition with for that oil.
There’s also the very real possibility that the world, in response to a whole lot of things, including a plummeting dollar and the fact that the world hates us, will switch to the Euro as the denomination by which oil is traded. If that happens, and I think it will, it will be apocalyptic.
Finally, on this point, roughly half of our foreign trade deficit comes from oil — in that we buy other people’s oil and ship it here. As the price of oil goes up, our deficit goes up.
As for the second, interest rates, they have no where to go but up. More and more of our debt is being held by foreigners (as Paul points out, we’re not buying it ourselves (save Social Security, see below). Those foreigners are losing confidence. In order to assuage the increasing risk of US treasury bills and notes (once the safest investment in the world), interest rates have to rise in order to entice people (i.e. other countries) to buy them. Debt service will soon become the dominant item in federal spending.
And the third, Social Security. The Social Security Administration currently buys about $100 billion dollars a year of US debt (because SS runs a surplus). This, at least, represents domestic investment in our debt which is preferable to foreign investment (see above).
If the administration is successful in privatizing social security, even partially, then someone else will have to be found to buy part or all of that $100 billion shortfall. If that’s going to be foreigners, or even domestic investors, that will come at a very high price.
In short, we’re priming ourselves for a collapse of the American economy one that we may not be able to dig ourselves out of.
What can we do? Invest, while we still have the time and the money, in a massive domestic energy program. This will most likely come in the form of procedures to reduce realign energy consumption, not find new sources (there are none to be found, except nuclear, which we will have to develop breakneck). This will come at the severe expense of some industries (the airlines, trucking, automotive) but will also have the upside of providing massive domestic spending and investment in new industries.
Raise taxes. Fast. On those sectors most able to take the hit, namely those sectors which have seen the greatest tax cuts — corporations and the wealthy.
Reform corporations. Specifically, close loopholes which allow corporations to move their headquarters to tax havens, such as Bermuda, while still enjoying the protections of the US taxpayer (such as intellectual property protection, etc.). You move to Bermuda, fine. Let the Bermuda Government protect your assets.
Cut spending, drastically. We’re going to have to take the axe to corporate welfare ($100-150 billion/year) as well as defense spending. We’ve also got to do something about government healthcare spending which, ironically, means we’ve got to look at nationalized healthcare along the lines of the other first-world democracies.
greg
A weak dollar
Vance at BTD writes that it’s a mistake for the Bush administration to call for the revaluation of the yuan because it will weaken the dollar and make it harder for the US to finance debt: For years we have been able to fund any budget deficit cheaply …