Double deficits and the faith-based dollar
By Marshall Loeb, CBS.MarketWatch.com
Nov. 5, 2004
NEW YORK (CBS.MW) -- As if President Bush doesn't have enough economic and investment problems to worry about in his second term, here's a lollapalooza:
The United States has long been running not just one but two huge and expanding deficits. First, of course, is the familiar federal budget deficit. But then there also is the less well-known current accounts deficit, which comes from America's exports and imports, its payments from U.S. investments abroad and foreign investments in the United States. In brief, we simply buy much more than we sell abroad.
The United States has been able sit back and calmly watch these double deficits grow and grow simply because foreign lenders have been willing bankroll them. The lenders have accepted U.S. dollars in payment, mostly U.S. Treasury bills, notes and bonds.
The creditors have been willing to accept this paper without limit because the dollar is uniquely and completely convertible -- you can change your greenbacks into just about any other currency at any time, in any place. The dollar is also a faith-based currency; it is not supported by gold.
But the lenders lately have grown impatient with this game. They have been tiring of the buildup of the double deficits. They have grown a bit nervous about the U.S. economy. In consequence, they are less willing than before to lend money to the United States to cover these deficits, and take dollars without end.
If these foreign lenders ever stop accepting unlimited amounts of dollars, it would cause grave economic woes in the United States, and clobber America's bond and stock markets.
Already there are some danger signs.
As Harvard economics Professor Jeffrey Frankel points out, every year for the last four years, foreign private investors have funded less and less of the U.S. current accounts deficit, and foreign government investors have funded more and more of it. Meanwhile, the current accounts deficit is steadily rising, and now amounts to about 6 percent of the U.S. gross domestic product.
In the year 2000, government-run foreign central banks -- notably The People's Bank of China and the Bank of Japan -- bought $43 billion in Treasury securities, and thus funded only about one-tenth of that year's $413 billion U.S. current account deficit.
But in 2003 (the latest year for which there are full statistics), government-run foreign central banks swelled their purchases to $249 billion in Treasury securities, thus funding almost half of that year's current accounts deficit of $531 billion.
What happened? The government bankers presumably felt they had to step in when private investors showed some reluctance to buy. The bankers knew that if ever there were a serious shortfall in demand for Treasury securities, interest rates in the United States would shoot up in order to make those securities more attractive.
By becoming such a force in the Treasury securities market, foreign central bankers may gain some leverage in their economic relations with the United States. Says Morris Goldstein, a senior fellow at the Institute for International Economics: "In a dispute, you don't know how they will lean. It's uncomfortable to depend on the kindness of strangers."
This is a situation that has trouble written all over it, he adds. Some time in the next three to four years there will be problems. The only way to escape them, bankers at home and abroad agree, is to reduce the U.S. budget deficit and the current accounts deficit.
One way to do the latter would be to reduce the value of the dollar relative to other major currencies. That would increase America's exports, and cut its imports.
Another sure way to do that is for China to raise the value of its currency, the yuan. That would raise the price of China's goods in global markets, and thus reduce U.S. demand for those goods.
China's currency is greatly undervalued -- by 20 to 40 percent, according to some estimates. That is because China's economy has been growing at a breakneck pace of 8 to 10 percent a year, but Beijing has not raised the value of its currency relative to the dollar in 10 years.
The Chinese have been reluctant to risk the slowdown in exports -- and growth -- that a currency revaluation would bring.
But lately the Chinese have concluded that they are growing too fast and would be willing to slow the pace -- by raising the value of their money. Similarly, several other Asian currencies are undervalued and should be raised.
So the pieces are in place for some moves soon on the currency front that would tend to reduce the nagging U.S. current accounts deficit.
But even so, a daunting part of the problem would remain: to reduce the U.S. budget deficit, $412.6 billion in fiscal 2004. That will require all the familiar challenging steps: to reduce government spending, increase savings and enhance the economy's growth.
A market bonanza
The Dow Jones Industrial Average (DJIA: news, chart, profile) started the week slowly and finished with a post-election bang. It rose 26 points Monday, fell 18 on Election Day as early exit polls erroneously led markets to expect a John Kerry victory, rose 101 Wednesday, gained 177 Thursday and added 72 Friday. Overall, the average rose 360.07, or 3.6 percent. The Nasdaq Composite ($COMPQ: news, chart, profile) rose every day of the week and was up3.2 percent; the Standard & Poor's 500 index ($SPX: news, chart, profile) also rose 3.2 percent.