The Dollar Warning

In its first four years, the Bush administration paid little attention to fiscal responsibility, and the US dollar is paying the price.

Amid worries about bulging U.S. budget and trade deficits, the greenback dropped last week to a record low against the 5-year-old euro, a 12-year low against the Canadian dollar and a nine year low against an index of major currencies. Many analysts don't see anything that will stop the decline.

Plenty of supply-siders discount such talk, arguing that the budget deficit remains low as a percentage of GDP comparable to other countries, and that a weaker dollare will improve US exports. However, this fails to appreciate the extent to which the U.S. government's debt (caused by free-spending Republicans and Democrats) has been underwritten by foreign investors, especially China and Japan. Asian holdings in US government debt give these nations enormous potential leverage over the US, since the consequences of them selling their holdings would prove difficult for the US.

A cheaper dollare reduces the value of American securities, making them less attractive to foreign investors. That could eventually precipitate what [Sadakichi Robbins, head of global fixed-income trading at Bank Julius Baer] called "the doomsday scenario" - Japan and China not only refusing to buy U.S. bonds, but selling some of their $1.3 trillion in reserves.
The only way Uncle Sam could then find new customers for its IOUs would be by raising interest rates. And although higher rates are good for savers, they would be disastrous for a country weaned on cheap credit.

Such higher rates would drive up sharply the cost of borrowing money here in the U.S., slamming the brakes on an already fragile economic expansion and sending more US consumers - already strung out like heroin addicts on too-readily available, high interest credit card debt - straight into bankruptcy proceedings. Moreover, a lower dollar does not readily translate into stronger US exports since a substantial portion of the US trade deficit is with China, whose currency, the yuan, is pegged to the dollar. Thus, cheaper US dollars will not make US goods any less expensive to Chinese buyers. The US government has been pushing for the Chinese to decouple its currency from the dollar, without significant success (for obvious reasons).

But a weakened dollar may have a more troubling consequence. For most of the last century, US investment have been considered the gold standard of stability for foreign investors. A substantially and consistently weakened US currency could signal a change in that perceptions.

In August, the most recent period for which there's data, foreign private investors sold $2 billion more in U.S. stocks than they bought, the Treasury said. Meanwhile, they dumped $4 billion more in government bonds than they purchased.
"A run for the exits could happen any day now, that's for sure," said C. Fred Bergsten, author of "Dollar Overvaluation and the World Economy" and director of the Institute for International Economics, a Washington think tank.
Such a prospect creates a tricky balancing act for policy makers. As long as the dollar devalues in a slow and orderly way, and doesn't trigger panic selling of American securities, Bush administration officials appear to be comfortable with the fall. As they see it, the benefits of boosting the economy throught higher exports outweigh the drawbacks.
The administration approach could work out fine in the short run, economists say. But eventually the slide must stop. Few countries can maintain strong economies with a debased currency.
Indeed, if a weak currency was the prescription for long-run economic health, countries like Argentina and Mexico - which have suffered massive currency devaluations in the last decade - would be financial titans.

Ironic, considering that the Bush administration seems intent on importing a significant percentage of the Mexican population into the US.