Saturday, November 27, 2004

De$cent of the Greenback (more)

More to add to the chorus of experts sounding alarms about U.S. deficits and the falling dollar.

"On Monday [Nov 22], Morgan Stanley economist Stephen Roach suggested that a steadily weaker dollar would be a good thing for the U.S. and the global economy -- barring a rapid crash. On Tuesday, he got company from Larry Horwitz, senior industry economist at Decision Economics." Source: Embracing a Weak Buck

Last week, in a private meeting, Stephen Roach was much more negative:

"Stephen Roach, the chief economist at investment banking giant Morgan Stanley, has a public reputation for being bearish. But you should hear what he's saying in private. Roach met select groups of fund managers downtown last week, including a group at Fidelity. His prediction: America has no better than a 10 percent chance of avoiding economic armageddon." Source: Economic 'Armageddon' predicted By Brett Arends/ On State Street. Tuesday, November 23, 2004

Here's the outline of Roach's argument: The size of the U.S. trade deficit means the dollar will keep falling. The Federal Reserve will have to raise interest rates in order to fund the debt. As interest rates rise, American citizens, "who are in debt up to their eyeballs," will become insolvent and there will be a "spectacular wave of bankruptcies." The economy will break.

The argument is supported by lots of facts: Every day, the U.S. brings in $2.6 billion from foreign sources, mostly in Asia, to finance the current account deficit (which, you'll recall, is the difference between all the outgoings and incomings). This is 80% of the world's net savings and can't be sustained. The level of household debt in the U.S. equals 85% of the economy. Most people opt for flexible interest rates for new and refinanced mortgages, leaving themselves vulnerable to rate hikes. Paying interest bills now takes up a record share of disposable income and the proportion will grow quickly as interest rates rise.

The main question is how fast the dollar will fall. If the descent is gradual, the international financial community -- with a lot of arm twisting by the U.S. -- should be able to manage it. Otherwise, things could get nasty.

The article says that the Federal Reserve might save the U.S. by letting inflation increase as interest rates increase. If inflation increases fast enough, people get to repay loans with dollars that are significantly cheaper (worth less) than the dollars they borrowed. This is a dangerous way of diminishing debt, however, because it alienates lenders who are then likely both to take their business elsewhere and to demand much higher interest from the U.S.

Other reports give insight into the difficulties of managing the decline in the dollar's value:

An article in the AustralAsian Investment Review
(Once Upon A Time in 2005 November 24, 2004) says that Europeans have stopped buying U.S. Treasury securities and no longer invest in U.S. businesses. This means it's up to the Asians to save the U.S. economy from collapse. To do this they must allow their economies to grow more rapidly and increase the proportion of their production that is bought by customers who are not Americans. They, particularly China, are unwilling to do this. But because they are so heavily dependent on exports to the U.S., they cannot sit back and watch the U.S. economy collapse. They have very strong motives for cooperating with the Federal Reserve to prevent that collapse. The article concludes: "[T]he key element is China. [I]f the Chinese relax their current US$ peg and allow Asian currencies to appreciate against the greenback, global economic growth would no longer be artificially fed through low US interest rates but through sustainable domestic demand growth outside the US, and that, in essence, would make for a better world."

An article in Asia Times Online (SPEAKING FREELY
Crisis towers over the dollar, by W Joseph Stroupe) adds a Russian variable. It says the central bank of Russia has shifted its holdings of foreign currencies. It held 75% of these reserves in dollars a year and a half ago, but now holds only 50% in dollars and the rest in euros. The change in Russian policy may cause Asian central banks to attempt a similar shift. If they try to do that, the U.S. could find itself having to raise interest rates much more rapidly than the Federal Reserve wants and a rapid rise in interest rates could bring on the problems that Stephen Roach discusses.

Today's New York Times has an interesting update and overview. See Foreign Interest Appears to Flag as Dollar Falls, by Edmund L. Andrews, November 27, 2004.

A recent publication from the U.S. General Accounting Office gives background information and data to support these arguments by the economists. It's mostly about domestic problems, not international finance. It points out the difficulties that lay in our future: aging population, decrease in size of labor force, anticipated Social Security and Medicare shortfalls, large deficits, low savings rates, dependence on foreigners to support the federal debt, It also points out the difficulties of sustaining a high level of economic growth in these conditions and say that declines in economic growth will result in lower living standards: "The fiscal policies in place today — absent substantive entitlement reform and dramatic changes in tax and spending policies — will result in large, escalating, and persistent deficits that are economically unsustainable over the long term. In other words, today’s policies cannot continue forever."

Regarding international finance, the report, GAO-04-485SP, Federal Debt: Answers to Frequently Asked Questions, says that the high levels of personal debt of Americans together with the negative effects of current fiscal polices and demographic trends will result in "rising inflation, higher interest rates, and the unwillingness of foreign investors to invest in a weakening American economy." The report points out how much the U.S. is already dependent on foreigners to finance the deficit (in Sept. 2003 foreigners held 37% of U.S. debt) and points to major risks of this dependence, including the possibility to which Stroupe alludes, that the euro "could eliminate the unique advantage held by U.S. securities — a broad, deep market for low-risk securities denominated in an easily convertible currency. As the market for euro-denominated securities broadens and deepens, euro-denominated debt securities could become a closer competitor for U.S. Treasury securities."

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