Rouille

Meanwhile, articles such as this NYT piece (A Field Guide to the Falling Dollar) are becoming daily occurences, all warning about the dollar's likely decline and basically saying that the only uncertainty is whether this decline will be rapid (bad) or slow (better).

These issues are inextricably linked and I'd like to provide my view on the subject. It's a bit long, but I hope you will find it worthwhile.


What these two things have in common is that they are the simple reflection of the real underlying cause of all the current unbalances in the world economy - the USA consume more than they produce, and they rely on the rest of the world to provide the difference.

The USA have the amazing privilege of having their currency serve as the main currency of international trade and reserve - which means that others are willing to hold dollars even if they do not intend to use them to buy things from the US (which is usually the main reason for buying someone else's currency). This reflects America's economic pre-eminence, as well (and this is often forgotten) as a general trust in the US institutions which means that foreigners expect their dollars to keep their value. This has allowed Americans to borrow money from abroad in pretty much unlimited amounts and at really good terms. This has in turn, mechanically fueled imports (if you have more money than you can spend locally, you spend it elsewhere).

So two first items to remember:

• the USA get a really good deal from the rest of the world
  
  
• US industry is not necessarily uncompetitive; it is structurally too small to fulfill all US needs

  
  
  

• for a good part of the world, wracked by inflation, nasty regimes and poor financial institutions, it is simply more convenient, safer and a better deal to keep your savings in dollars than locally;
  
  
• for everybody, it is really helpful to have a common currency to set prices and trade internationally, knowing that everybody else also accepts it. This has been compounded by the growing use of (mostly US-created) financial instruments backing commercial transactions that all require a common currency to provide liquidity.

  
  
  

• one myth is that foreigners get better returns in the US than elsewhere, thus ensuring that they do want to invest there. This is simply false. The US actually generate more income from their foreign investments than foreigners from their US investments, despite these now being significantly larger. Foreigners now own a growing proportion of T-Bills, which pay little, whereas US investors own good productive assets outside the US (which quite often provide for US demand). These low returns on US purchases are not a problem in normal times, but they do not provide an "objective" reason for further investment in the US economy;

  
  

• another myth is that it's Europe's "fault" if there are such unbalances, because Europe's economies are too sclerotic, Soviet, rigid, obsolete, etc and thus cannot grow and cannot "pull their weight" (i.e. importing more and "sharing the burden" with the US). Europe is barely a net exporter, but not very far from balance; Europeans live within their means and there is no rational reason to behave differently, so salvation will not come from here. (btw, it's quite a (framing) trick to have managed to call imports a burden, when it really means that others work and you enjoy their labor);

  
  

• meanwhile, the Asian economies, having built their prosperity on piggybacking the US economy, and developping their economic base by providing for the US needs and imports, are now stuck in the same vicious circle as the US - as they have a mercantilist approach, they keep their currencies pegged to the US dollar to stay competitive, and the way to do that when you have a large surplus of dollars is to either invest in the US or stock them. Obviously, the Asians do not seem to be interested in investing in the US (being busy investing at home - or in China - as quickly as they can), and they recycle these dollars in low-remuneration T-Bonds (rather than cash). With the current deficits, the pile of T-Bonds they own is becoming precariously high;

  
  
  

The difference now is that, for the first time, there is a credible alternative currency for both international trade and reserve: the Euro. It is backed by an economy and trading partner just as big as the US, and by institutions, despite all the criticism and nitpicking from the business press, that are fundamentally sound (rule of law, sound banking regulation, hawkish central bank, balanced trade, reasonable debt position).

At the same time, the US has gone on an amazing spending binge, fuelled by the dot-com bubble, then the real estate bubble and the Bush deficits. The binge has been made possible by Greespan's astonishingly loose monetary policy (and everybody's joyful embrace of debt) and a lot of it has been wasted in military spending which does not profit many and is certainly not recycled into the economy (the economic equivalent of armies and weapons building is to have the people involved dig holes in the sand and refill them - it does not create any value and it ties up a lot of people that could do better things. Up to a point, you can argue of its value as an insurance policy against trouble from the outside, but it is fair to say that the US are far beyond that point).

So there you have it

• longstanding overconsumption, a good chunk of it unproductive;
  
  
• a credible alternative
  
  
  

The ONLY way to solve this crisis is for the US to stop consuming more than it produces. This can come in many ways, of which the falling dollar is only a very indirect one.

A falling dollar, when the US imports twice as much as it exports (yes, double) has initially the following consequences:

• increase the cost of imports, expressed in dollars and decrease the cost, in other currencies  of exports for foreigners (which is obvious), which leads to an increased trade deficit as the monetary impact is immediate, as imports are immediately more expensive, but cannot be immediately replaced (and in some cases, like oil or many products not manufactured in the US, cannot be replaced at all). And any change in the value of imports has double the impact of a change in exports, as they are twice as big to start with;

  
  

• create potential losses for foreigners holding assets expressed in dollars. If these assets are productive (US factories or companies) this may not be so important, but if these are paper, liquid, assets (stocks and bonds, especially T-bonds), the investors will start worrying about the return on their investment. If they expect a continuing drop in the value of the US dollars, they may sell to cut their losses, thus creating a self-fulfilling peophecy (remember, you don't just need foreigners to hold on to their T-Bonds, you currently need them to buy an extra 2-billion-dollars worth of them EVERY DAY). A devaluation of the dollar is a default by stealth - you take away a portion of the value for all non-US based investors. A default, even if by stealth, is not trust-inducing, and we have seen that trust is the last thing holding the dollar now;

  
  

• the likely way to avoid a full scale run on the dollar is then to significantly increase interest rates in the US. This has several effects: (i) it compensates foreigners for the additional risk (from their perspective) of the falling dollar value, (ii) it dampens domestic consumption by making debt more expensive, thus limiting imports and the deficit, thus possibly recreating trust that the US is taking a more sustainable financial path, but (iii) it will have an immediate impact on the real estate market, by making variable-interest mortgages more expensive thus strangling some borrowers (more sellers, including distressed ones) and at the same time reducing the price people are able to pay for houses (less buyers). Real estate being the main source of wealth for most US households, this will have a direct impact on all - no refinancing of your credit card debt by drawing house equity, reduced consumption, more bankruptcies, etc... It will not be pretty.

  
  
  

Meanwhile, your weaker currency has the following long term effects:

• oil producers, who currently get paid in dollars, are not happy with the continued erosion of the purchasing power of the dollars they get. They spend most of them in Europe, and thus need Euros. They thus expect their oil to at least keep its purchasing power in euros, which means that, if expressed in dollars, the price must go up as the dollar falls. The Europeans don't really care, because the price for them will stay constant in euros. Americans, who have big gas-guzzlers and do not have heavy taxes that could cushion these movements, will feel the increase very directly at the pump; as an absolutely non substitutable import, this will only increase the deficit with no chance of a reduction other than serious reduction in consumption, which will be a consequence of economic hardship rather than going for substitutes (public transport), which are totally unavailable for most Americans.

  
  

• holders of T-Bonds will need to be convinced to hold on to them - and to keep on buying more of them. The thing is that they are so little diversified tday that any move to change the balance of their reserves (inevitably towards the euro) has an immediate impact for the dollar, as we currently see - and for the interest rates required to keep them happy. Asian central banks may want to hold on longer than others, as they have the incentive of protecting their exports, but others (especially the oil producers of the Middle East and Russia) have growing incentives to bolt out before it gets worse. And Asians may decide on day that enough is enough, and you could have a real meltdown.

  
  
  

- a commitment by the US to live within their means (this needs not mean zero deficit, but at least shrinking ones). This applies both to the government (the federal budget deficit - which need to be cut seriously) and to consumers (an orderly slowdown in consumption - which requires increased interest rates, again). This is purely domestic stuff - foreigners can do nothing to change that.

This gets me back to outsourcing and offshoring. Offshoring is just a new way to import more - except that it's imports of services instead of imports of goods. It was inevitable that the USA's insatiable demand - a growing portion of which is services - would require foreign input. Tradeable services naturally come into this mix (as opposed to non tradeable ones, such as getting a haircut or cleaning your pool). This movement is not a sign that US workers are uncompetitive as a whole, it simply means - again - that they consume more than they produce. Of course, some sectors may see real job destruction and upheaval due to foreign competition, but others are growing and hiring - tradeable services (banking, insurance, IT) is actually one of the few areas where the US has a trade surplus.

A falling dollar will not "solve" outsourcing if it does not lead to a rebalancing of domestic demand/production, and that will come only through massive changes in domestic consumption patterns.

So, the US can go on blaming foreigners all it wants, it's useless and counter productive. Foreigners have fed the massive overconsumption of the Americans over the past years; the smartest of them have managed to use that fact to build their economies, but they have not created it and they have certainly not repaed as many benefits as the Americans have. America has abused the privileges granted by the status of the dollar as the lone world currency beyond all reasonable repair; now it's time to pay back.

Europe will only marginally suffer, as they have balanced trade, limited exposure to the US market relative to their overall size, and a specialisation in high-quality goods that are not so price-sensitive (German exports worldwide increased by 14% this year despite the falling dollar).

non-China Asia will benefit from the increasing size of the Chinese economy (to which they are a massive net exporter) and will hopefully learn to develop more their domestic markets;

China is the most interesting case; they are likely to bear the brunt of falling US imports; on the other hand, a slowdown is probably eaxactly what they need after the overheating of the past few years; It may relieve the tensions on commodity markets that have seen stupendous increases in Chinese demand in a short time - and the corresponding price increases. The balance may not be so easy to find, but one must not forget that Chinese trade is pretty much balanced (exports to the Us being compensated by massive imports from the rest of Asia) and the country itself is not on an unsustainable export-only growth path as it busily develops its internal market and demand.

Again, the adjustment will fall mostly where it has to - US consumers. And again, this says nothing about the competitivity of US workers - only that when consumption is the priority, production cannot be - but this may well change soon...