Verbalism Personified

Prelude to Disaster?

With the American dollar weakening against the Singaporean and Australian, it seems like a good opportunity to buy in on the cheap while anticipating a global economic resurgence in Two Thousand and Five.

Or is it?

Could this slide be attributed to American fiscal policy, that if left unaddressed, be ultimately its undoing?

After the Second World War, the dollar has been the leading international currency by which nations trade and base their foreign reserves on. However its dominant role cannot be taken for granted. If America keeps on spending and borrowing at its present pace, the dollar will lose its mighty status in international finance.

That status is certainly high privilege. Not only does the US Federal Reserve print the world's reserve currency, America can borrow on far better terms than any other country on earth. If you were given such a priviledge, you'd take care to hang on to it. At present, America doesn't seem to be taking that priviledge seriously.

What will it cost?
Over the last three years, the dollar has fallen thirty five percent against the Euro and twenty four to the Yen. This slide is indicative that America has an unacceptable practice of rampant government borrowing, consumer spending and bulging a current-account deficit big enough to bankrupt any other country.

This makes a devaluation inevitable. However policymakers are more than happy to let the dollar slide further as an attractive option for a heavily indebted America. Yet this move is not only dangerous, it is bad for investor confidence.

A second troubling sign is that the global financial system has become a giant money press due to America's easy-money policy. Total global liquidity is growing faster than ever before. Emerging economies that peg their currencies against the dollar, are amplifying the Federal Reserve's loose monetary policy by artificialy devaluing their currencies as they print local money to buy dollars. This gush of liquidity flows into equity and real estate prices around the world, inflating a series of asset-price bubbles.

America's current-account deficit is at the heart of these concerns. The deficit is predicted to rise to eight hundred and twenty five billion by Two Thousand and Six, or six point four percent of America's GDP. Optimists argue that foreigners will keep financing the deficit because American assets offer high returns and a haven from risk. However private investors have already turned away from low-yield dollar assets and have pursued higher returns from Europe and Japan. Also a sliding currency can hardly be regarded as a wise investment.

In a free market, the dollar would be far weaker without the massive support of Asian central banks. But such support has its limits, and the dollar now seems likely to fall further. In economic terms, it amounts to a disaster.

Periods of dollar decline have often been unhealthy for the world economy. Some would argue, like in the late nineteen eighties, the falling dollar had few ill-effects on America's economy. But it played a big role in inflating an asset bubble in Japan by forcing Japanese authorities to slash interest rates.

This time round, it seems that everybody is trying to blame someone else. America says its external deficit is mainly due to sluggish growth in Europe and Japan, and to the fact that China is pegging its exchange rate too low. Europe, alarmed at the “brutal” rise in the euro, says that America's high public borrowing and low household saving are the real culprits.

There is some truth to both these claims. China and other Asian economies should let their currencies rise, relieving pressure on the euro. It is also true that Asia is partly to blame for America's consumer binge as its central banks' large purchases of Treasury bonds have depressed bond yields, encouraging households in the United States to take out bigger mortgages and spend the cash. Europe also needs to grudgingly accept, that a weaker dollar will be a good thing if it helps to shrink America's deficit and curb the risk of a future crisis. At the same time, Europe is also right when it says that most of the blame for America's deficit lies at home. America must cut its budget deficit. This is certainly not an option as a cheaper dollar and higher American savings are both needed if a global financial meltdown is to be avoided.

Another way?
It is certain that American policymakers are relying on a depreciating dollar to solve all their problems. Unfortunately this is dangerously short sighted as it leaves the global economy flapping in the wind and will ultimately prove to be far more painful than imagined.

America must reduce its current-account deficit to a level that foreigners are happy to finance by buying more dollar assets. This in turn would persuade existing foreign creditors to hang on to their vast stock of dollar assets. At an estimated eleven trillion, this is not chump change. If the dollar falls by another thirty percent, it will wipe trillions off the value of their holdings. That would essentially be the biggest default in history, destroying faith in the American dollar in the process.

The dollar’s loss of reserve-currency status would send America’s creditors calling. Once that happens, the dollar will depreciate further causing bond yields to soar. This in turn would result in a deep recession. Americans favoring a weak dollar should be careful what they wish for. Reducing the budget deficit is a vastly cheaper alternative.

posted by Teutoburg @ 2:20 PM