theskeptic's Journal: Behind Big Drop in Currency: Imbalance in Global Economy

Behind Big Drop in Currency:
Imbalance in Global Economy

U.S. Soaks Up Asia's Output
By Going Deep Into Debt;
Something Has to Give
Getting Others to Consume
December 2, 2004
The U.S. dollar is drooping. It's down about 9% against other major currencies since August. That's often the headline, but it's not the problem. The weak dollar is actually a symptom of a global economic malady -- and it's also part of the cure.

The problem is that the world economy is out of whack.

Americans have become global consumers of last resort, gobbling up far more than the U.S. produces by importing from economies that churn out far more stuff than they can digest at home. They send us things to eat, wear, drive and plug in. We buy from thriftier economies, mainly in Asia, and they lend us $1.8 billion every day.

This has been a good deal for Americans. We've been able to live beyond our means. Interest rates have stayed low because foreigners have been happy to purchase gobs of debt issued by the U.S. Treasury and mortgage giants Fannie Mae and Freddie Mac. Morgan Stanley economist Stephen Roach, who has been calling for the "need to rebalance" for months, dubs these overseas investors "the global enablers." If not for the flood of foreign money, he figures, U.S. long-term interest rates would be between one percentage point and 1.5 points higher.

The ability to borrow without pushing up interest rates has also been a boon to the Bush administration. "The federal government, enjoying low funding costs, can have its cake and eat it too, boosting spending on both defense and social programs without having to resort to tax increases," says Barry Eichengreen, an international economist at the University of California at Berkeley.

UNCHARTED TERRITORY

The U.S. current-account deficit is breaking records. See a chart of the currnt-account balance as a percentage of gross domestic product.

The folks on the other side of the oceans have benefited, too. Exports kept Europe growing despite the Continent's perennially thrifty consumers and inflation-phobic central bankers. Goods sold to the U.S. also kept Japan's stagnation from being even worse. U.S. markets and leading-edge technology companies offered foreign businesses and investors a more profitable place for their savings than home markets, particularly during the 1990s boom years. And China and smaller Asian economies, in some ways mimicking the earlier success of Japan and Korea, looked to strong exports to lift people out of poverty and recover from the rocky years of the late 1990s.

To keep those exports attractive to U.S. consumers, Asian economies have pegged their currencies to the dollar (China, Hong Kong, Malaysia) or actively sold them for dollars (Japan, Korea, Taiwan). That keeps their currencies weaker against the dollar than they otherwise might have been.

The result: Huge dollar hoards in Asian central banks, more than $1.8 trillion now, most of it in the form of U.S. government securities. They have, in essence, taken the money the U.S. sent them to buy imports and lent it back to the U.S. This, of course, gives China and Japan a very big reason not to let the U.S. economy or the dollar tank.

So we save very little, buy a lot and enjoy lots of imported goodies. Other countries save a lot, sell a lot and enjoy lots of export jobs. We borrow. They lend. For a while, nearly everybody -- save Americans whose jobs or profits were threatened by imports -- was content.

LOSING CURRENCY

See who wins and who loses with a weak U.S. dollar.
But now that the dollar, which had peaked in early 2002, is sliding again, it's clear that the game is changing -- and that foreigners are growing reluctant to hold ever-more dollars. "A diminished appetite for adding to dollar balances must occur at some point," Federal Reserve Chairman Alan Greenspan said in a recent speech, adding quickly that, so far, he sees "only limited indications" of resistance to lending to the U.S.

The gap between U.S. exports and imports and the amount of U.S. borrowing is getting uncomfortably large by historical standards. The U.S. is expected to borrow $670 billion this year from the rest of the world, according to estimates this week by the Organization for Economic Cooperation and Development.

That works out to an unprecedented 5.7% of the U.S. gross domestic product -- the nation's total economic output -- about twice as large as many mainstream economists consider sustainable. Even in the most profligate years of the 1980s, the current-account deficit, as it's known, never got bigger than 3.3% of GDP. Indeed, though international trade and investment grew markedly in the decades after World War II, it's only been since 2000 that the U.S. economy has become so enormously dependent on the savings of foreigners, Mr. Greenspan noted.

Twenty five years ago, the value of overseas assets held by U.S. companies and citizens was far higher than the assets foreigners owned in the U.S. But years of selling U.S. assets like stocks, bonds, companies and real estate have turned that upside down. The value of U.S. assets abroad is now far less than foreign-owned assets in the U.S. The net difference: nearly 25% of GDP.

If policies and exchange rates remain unchanged (which is unlikely), the figure is on track to double to 50% of GDP in a decade, the OECD says. That would force the U.S. to set aside more of its income each year to pay interest and dividends to foreigners. And eventually, like a highly leveraged company, the U.S. would have to pay higher interest rates to keep creditors lending. "At some point, the game has to end. When, we don't know," says Michael Mussa, the former chief economist of the International Monetary Fund.

Simply put, the U.S. -- either voluntarily or forced by markets and the rest of the world -- has to save more and buy less, particularly from other countries. Other countries, in turn, have to save less and buy more, particularly from the U.S. And if that's to happen in a growing world economy, the economies of Europe, Japan and China need to rely more on demand from their own consumers, and less on demand from Americans.

That's where the dollar becomes part of the cure. A precipitous decline in the dollar would rattle markets and could provoke a global recession. But a more gradual drop -- like the one under way -- makes U.S. exports cheaper to buyers in other countries, and it makes imports pricier to Americans. It will take a while for that to work through the system, but history suggests that it will restrain U.S. imports and boost U.S. exports.

But there are a couple of things standing in the way of the weaker-dollar fix.

One is that China, so far, has refused to let the yuan rise against the dollar. "If the dollar is to go down, other currencies have to go up. It's hard to find a better candidate than China," says Morris Goldstein of the Institute of International Economics, a Washington think tank.

China is important not just because of its size -- it now represents about 13% of U.S. imports -- but because smaller Asian economies are reluctant to let their currencies move much against the dollar until arch-competitor China does. That has left other currencies, notably the euro, to absorb the full effect of the dollar's decline. The U.S., Europe and the IMF are pressing China to unfetter the yuan so it can rise against the dollar. Many economists argue that this is in China's self-interest: It would help cool what may be an overheated economy, give China the room that other big economies have to move interest rates when appropriate and let China invest more in its own economy instead of putting so much into U.S. Treasury bills. Chinese officials nod but offer no timetable.

A second problem is that imports and exports these days aren't quite as simple as they once were -- which could make it harder for the foreign exchange market to do its job. A growing portion of crossborder trade occurs inside big multinational corporations, as U.S. companies like Ford Motor Co. make cars in Mexico and German firms like BMW make cars in South Carolina. About 20% of all U.S. imports now occur inside big companies, according to a new report by McKinsey Global Institute, the think-tank arm of the consulting firms. These flows are often driven by corporate strategies, not simply currency rates, and may not respond predictably when the dollar falls.

In fact, the lower dollar can do only part of the job. Nearly all the economic doctors advise the U.S. to take steps to save more so it relies less on foreign borrowing, and most of them say that means cutting the federal deficit.

There are three ways the U.S. can save -- as families, as companies and as governments. U.S. businesses are saving a lot these days -- in part because they've been reluctant to invest. American families aren't saving very much. The Commerce Department said yesterday that Americans saved only 0.2% of their after-tax income in October.

But the big change in overall national savings -- and the short-term cause of the leap in U.S. borrowing from abroad -- is the federal government's big deficit spending over the past few years. Even President Bush, who pooh-poohed warnings about the budget deficit in his first term, now makes the link between deficits and the dollar. "The best way to affect those who watch the dollar's value is to make a commitment to deal with our short-term and long-term deficit," he said after meeting with counterparts from Pacific Rim nations in Chile last month.

And if the U.S. saves more, then the rest of the world has to spend more to keep the global economy growing. "Other countries have got to find some other source of growth to make up for the loss of exports or they will grow more slowly as a result of their appreciated currencies," says Stanley Fischer, a prominent international economist who is now vice chairman of Citigroup.

Write to David Wessel at [e-mail]