Washington faces two options for righting its red ink. One is to cut the deficit, perhaps by raising interest rates to discourage borrowing, but that risks choking off recovery as the November election approaches. The other is to let the dollar fall, making it cheaper for foreigners to fund America’s shopping. Federal Reserve chairman Alan Greenspan made the U.S. choice plain when he told a Berlin audience last week that the dollar’s decline was not a worry.
The United States has the advantage of owing money in its own currency, thanks to the fact that the dollar happens to be the world’s reserve currency. This prevents a weaker dollar from triggering the kind of meltdowns that hit emerging markets in the 1990s. These crises exploded precisely because countries like Thailand, Mexico and Argentina borrowed heavily in a foreign currency. The fall of the baht and the peso make it impossible for local governments or banks to repay dollar loans, leading to widespread defaults.
So far, the slide has been smooth, at least for the United States and Asia. The Bush campaign is getting exactly what it wants, because a weakening dollar fuels U.S. deficit spending (Austin, Texas, home buyers can get a mortgage with no money down) and export sales. Asia is not hurt, either. With the yuan pegged to the dollar, China’s exports are still streaming onto American shelves at steadily low prices, damping the threat of inflation that often follows a falling currency. Indeed, Greenspan last week ruled out inflation as an immediate threat. That leaves all the pain of the falling dollar on Europe’s head. Over the last two years, the dollar has fallen 15 percent against a broad basket of currencies, and 40 percent against the euro. Much of corporate Europe is well hedged, but nervous politicians in France and Germany have launched a campaign to talk the euro down. European Central Bank president Jean-Claude Trichet last week called the currency movements “brutal” for exporters. One sign of trouble ahead: some Germans are now reimporting BMWs and Audis from America. Despite the high cost of shipping and refitting cars to European standards, the weak dollar still makes it cheaper for Germans to buy German cars in the States.
The dollar decline may yet turn disorderly. Berkeley, California, financial historian Barry Eichengreen says the main threat is a 2004 version of the collapse of hedge fund Long-Term Credit Management, which went bankrupt in 1998. Just as LTCM foundered when a falling ruble undermined its Russian investments, some big bank could be caught in a bad currency bet, undermining confidence in the markets.
For its part, the IMF’s great fear is that the rising U.S. trade and budget deficits could compel the Fed to raise interest rates to attract enough funds to cover the debt, a move that would snuff out growth and threaten the global economy. Asia is growing fast, but its consumers don’t yet spend enough to pull the world out of trouble. Europe is no help because despite the mighty euro, what strength it has comes from exports, not domestic spending.
Support for the twin U.S. deficits is growing more precarious. Private investors poured money into the United States in the 1990s, but the deficit is now funded by Asian central banks, which are motivated by policy agendas that could change rapidly. UBS global economist Paul Donovan notes that 98 percent of the fiscal deficit is now being financed by Asian central banks, and in recent months, because it is nervous about the swelling budget deficit, Japan has been increasingly holding dollars in normal bank accounts rather than U.S. Treasuries.
The worst-case scenario is a rerun of the 1930s. A dollar rout forces the rest of the world to throw up barriers against dirt-cheap U.S. goods. History teaches that protectionism can lead to depression, warns Bernard Connolly, global economist for AIG Trading in London. Eichengreen counters that globalization has progressed too far for that to happen. The world’s prosperity and security may well depend on whether or not he’s right.
