TCS Daily


Washington Fiddles While the Dollar Falls

By Desmond Lachman - November 24, 2004 12:00 AM

The steady decline of the US dollar to record lows on almost a daily basis should be sounding alarm bells in Washington. Instead, all it elicits from Washington is the tired repetition by Mr. Snow, the US Treasury Secretary, of the increasingly less credible refrain that the United States believes in a strong dollar policy. This is a great shame. For, as Alan Greenspan so strongly hinted last week, unless the underlying causes of the dollar's weakness are soon addressed, the US runs the risk of a full blown dollar crisis, which could very well undermine the economic recovery.

Over the past two years, the dollar has shed almost 40 percent of its value against the euro. This has not been the mere result of the vagaries of the international capital market. Rather, it has been a reflection of the growing concerns in those markets about US profligacy and about the increasing tendency of the United States to live considerably beyond its means. Markets are taken aback not only by the fact that US households do not save, but also by the heightened realization that the US government is now awash in red ink for as far as the eye can see.

Never before over the past hundred years has the gap between US imports and exports been so large in relation to the size of the economy. Never before has the US been so indebted to foreigners as it is today. Sadly, there is every indication that this situation will only get worse in the years ahead unless there is a major change in US economic policy direction that reverses the abysmal US savings performance.

The deterioration of the US net international investment position at an annual rate of 5 percent of GDP is now very much on Alan Greenspan's mind. Last week, he correctly observed that net claims against US residents could not continue to increase forever in international portfolios. He was also right in warning that resistance to finance the deficit, with its attendant consequences for US interest rates, would occur well before debt service becomes an issue.

Contrary to what the Treasury would have us believe, the US external payment imbalance is not a reflection of foreigners' hunger to invest in US companies and in the US stock market. Alas, those days went with the bursting of the equity bubble in March 2000. Instead, the main factor now holding up the dollar is the massive purchases of US Treasury paper by foreign central banks, which now finance an unprecedented 50 percent of the US external deficit. They do so not because they believe that the US is an attractive place in which to invest. Rather, they do so as a means to keep their currencies cheap in relation to the dollar so as favor their export sectors.

Depending on foreign central banks to support the dollar is a very thin reed on which to base a dollar policy. Already some foreign central banks, notably those in India and Russia, are showing clear signs that they are tiring of having to accumulate ever-increasing amounts of depreciating dollar paper. They also fear the loss of domestic monetary control and inflationary pressures that flow from having to issue currency to prop up the dollar. It is only a matter of time before other central banks too balk at the potentially large costs to their balance sheets of continuing to pile up dollar holdings in magnitudes that have no historic parallel.

As Alan Greenspan suggests, any serious solution to the US balance of payments problem must begin with a substantial reduction in the US budget deficit as part of a strategy to improve US savings performance.

It would be a grave mistake for Washington to count on endless forbearance in the world currency market while it fails to address the US budget deficit problem. For when currency markets lose confidence, they can be brutal and they can wreak havoc on the equity and bond markets. One can only hope that Washington heeds the alarms already sounding in the currency markets and stops fiddling about the budget before it is too late.

The author is Resident Fellow, American Enterprise Institute


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