BF2S Forums Will the dollar recover?

pierro wrote:

-The sinking dollar value in the United States is a positive, not a negative (as was implied in the question)...I am no economist, but I am using the reasons from New York Times columnist and PhD economist Paul Krugman:
-A weakening dollar will not affect purchasing power of the citizens (Even with the dollar weakening people are still buying just as much)...there is no way Honda will start raising its prices, America is too valuable a consumer
-Most American companies have their assets in infrastructure or investments in other company's (many of them in other countries) and their debt in dollars

-Also, when it comes to economics, trade is overrated as it does very little to GDP (although it is still a factor) and is net beneficial (see the concept of comparative advantage)...the American debt isn't a huge issue either, countries like Canada and Japan have a far larger debt...also America is living 30% better (in terms of gdp/capita) better then any other developed country and living a few percentages beyond their means...finally the Iraq war etc... isn't a big issue, its like 1% of the budget, a fraction compared to Cold War spending

CameronPoe wrote:

why exactly the dollar is plummetting headlong into the abyss of worthlessness.

US Current Account Deficit

Over the past 2 decades the USA current account deficit has increased to a point where it has become a major concern to the global economy with unknown, possibly dire consequences prevalent. With economic boom, the US has seen unprecedented consumer spending, increased imports and generally spending beyond their means, while many trade partners have seen depression, low consumption and high savings. With no corrections through the financial markets and major trading partners using trade surplus monetary and fiscal policies to strengthen their economies there seems to be no respite in sight.

Structure of the US current account Deficit
The US current account in 2004 hit a record of $666 billion deficit, amounting to 5.7% of GDP after more then a decade of increases in CAD as a percentage of GDP. Since 1982 there has only been 1 year where the US did not experience a CA deficit (figure 1) and in no time in the past 2 decades has it seen a merchandise trade surplus, and as of 2001 the US had a net negative international investment of $2 trillion equivalent to 20% of GDP.

Figure 1: Current Account Deficit as a Percentage of GDP,
1987-2004

Source: Labonte (2005, 4)

This growth in CA deficit has in large to do with a rapid increase in merchandise trade deficit most notably with China which has grown from practically nothing in 1987 to about $162 Billion in 2004 or close to ¼ of the US total trade deficit. But the US has also increased its trade deficit with the rest of the world with only Japan taking a slight decrease in bilateral trade surplus over the same time (figure 2). The size of the CAD is practically equal to the merchandise trade deficit. Service trade, net foreign income and unilateral transfers account for negligible amounts and almost cancel each other out (figure 3).

Although the CAD is at worrying high levels, at the current time it is sustainable because Asia is willing to finance the deficit to keep their currencies undervalued. But this form of monetary policy is not long term sustainable with South East Asian countries already holding $1.8 Trillion is US reserves.

Causes of the CAD
Simply put the CAD exists because Americans are spending more on imports then they are producing as exports. This has been fuelled by:
•    A strong growing economy
•    Low interest rates
•    A strong exchange rate
•    Low private savings
•    Increased business investment
•    High government spending
•    More immigrants

These conditions over time should have stabilised, with foreign investment and exchange rate changes. But due to the Asian crisis, fixed exchange rates and foreign investment perceptions things have been kept artificially in place.

In the 1990s, America went through a technological boom, which increased productivity and output causing the stock market to rise, unemployment to fall and rates on business investment to increase. Households became richer and more confident of the future so increased consumption by spending their saving which fell from 6.5% of GDP in 1992 to less the 1% in 2000.

This has been further increased by the historically low interest rates, which has seen high borrowings, investment and consumption, but no increase in inflation to trigger an interest rate rise to reduce spending. The main reason for the lack of inflation comes from a multitude of cheap imports coming out of China and a relatively high exchange rate keeping those prices even lower. Even historically high oil prices has not increased inflation far enough nor slowed down consumption in other areas, but they have further increased trade deficits with the Middle East and Russia.

The appreciating dollar and devalued Asian currencies from the Asian crisis, and their insistence to maintain a trade surplus budget has made imports a very desirable commodity to US consumers, but also made exports more expensive to the rest of the world, causing other countries to find their goods elsewhere leading to the huge merchandise deficit.

This imbalance in trade should have devalued the US dollar making there exports more desirable and imports more expensive. But China, Americas major trading partner has had their exchange rate pegged to the $US keeping its value artificially low in order to keep an export surplus advantage and gather foreign reserve funds. Which it believes is the best way to maintain strong economic growth. This has had a follow on effect with other smaller countries who do not want to lose export sales to China also pegging the value of their currencies artificially low to maintain a competitive advantage. So even America’s use of bilateral trade restrictions with China has only seen the outflow of funds change destination not value.

With most American savings being used to buy cheap Asian products, they are unable to fund the high investment levels the economy requires. Compared to Asia where they have very high savings levels, and see America as a better place to invest then their home countries, to capture the high, secure returns, sees foreign purchases of US assets increase from $100 and $250 billion between 1985-1994 to over $1 trillion in the year 2000 (Figure 3). This demand for American dollars to invest has kept the exchange rate to similar real values of 15 years ago. With the increased funds there have been increases in innovation and productivity which further increases the desirability of US assets. With this increased investment, more funds in form or interest and other returns on capital have been flowing out of the country back to their foreign investors further opening the CAD.

High government spending has also seen the American fiscal savings to go negative 0.2% of GDP in 2002 after almost 2 decades of surpluses, but again can not account for the huge CAD of today, but is doing nothing to ease the problem either.

Americas increased numbers of immigrants which have doubled since the 1960s. These immigrants maintain their desire for home products, so purchase a large percentage of imported items. They also send money home to their families which increases capital outflow of funds. Although a factor, with only 10% of the population classed as an immigrant, this in no way can account for the size of the CAD.


The US CAD has reached record levels, but currently is being financed by China and other South East Asian countries which have excess savings from trade surplus. Although changes in macroeconomic policies and more flexibility in Asian currency exchange rates may help reduce the CAD, the savings and consumption imbalances are the real cause for the expanding trade deficit. While America continues to spend its savings on cheap Asian imports and Asian continues to save their trade surpluses they will be there to met the investment short fall faced by the US. Barring a US economic slow down with out the need to increase interest rates to both cut consumer spending and reduce foreign investment or for Asian countries to use their new found wealth on consumables the current situation is likely to expand. Although the situation seems sustainable for the short to medium term, the long terms effects are unknown and may result in a global recession.

References
Macfarlane I.J. (2005), “What are the Global Imbalances?” Reserve Bank of Australia Bulletin, October, 19-27.

Boltho A. (2004), “China – Can Rapid Economic Growth Continue?”, The Singapore Economnic Review, 49 (2), 255-272.

Lee J.W., McKibbin, W.J. & Park Y.C. (2006), “Transpacific Trade Balances: Causes and Cures”, World Economy, 29(3), 281-303.

Mann C. L. (2002), “Perspectives on the U.S. Current Account Deficit and Sustainability”, Journal of Economic Perspectives, 16(3), 131-152.

Bown C.P., Crowley M.A., McCulloch R. & Nakajima D.J. (2005), “The U.S. Trade Deficit: Made in China?”, Federal Reserve Bank of Chicago Economic Perspectives, 4th Quarter, 2-18.

Labonte M. (2005), “Is the U.S. Current Account Deficit Sustainable?”, CRS report for Congress.

Summary
As the US Current Account Deficit (CAD) continues to rise relative to GDP, economists argue that at some point the CAD will become too large to sustain itself and unless there is some government intervention will send the world into a possible global recession. The amount of capital inflows that are needed to sustain the size of the CAD can not continue for ever. At some point the world will have its fill of US assets or the increasing liabilities the country faces will deter further investment. Once this happens the US dollar is bound to fall which if left unchecked could see major trade flows disrupted, oil trades change currency and eventually send the world into a global recession. To counter these future possibilities the 2 major players in the CAD must make policies changes. The US needs to reduce its import spending without any major effects on the domestic economy, which can be achieved through a retail import tax. China on the other hand must give up some of its trade advantages by floating its currency and increasing fiscal spending to create a higher domestic demand. These policy changes may in the short term seem unjustified, but should bring about longer term sustainable growth.

The Current Account Deficit
Changes in macroeconomic policies and more flexibility in Asian currency exchange rates may help reduce the CAD, but savings and consumption imbalances are the real cause for the expanding trade deficit. In the long run, because of the shear Size and scale of the US current account deficit, should there be any external shocks to the system, it could leave a huge hole in both the US and Global economies. The amount of foreign capital that is needed to fund the CAD can not for ever go on increasing and at some point there must be a correction.

Some economists argue that the size of the CAD could have adverse effects on the US and/or Global economies. These scenarios could include:
•    Changes to investment sentiment and lack of confidence in US markets.
•    Increased interest and dividend payments.
•    Increased fiscal spending

Should foreign investors see the large CAD as harmful to potential returns, they will stop buying US assets (or start selling them). The US needed over $800 billion in foreign investment during 2005 and that figure is growing annually. A fall in confidence and foreign investment would see the US exchange rate plummet, taking with them the fixed exchange rates of the Asian countries.

As the CAD grows, the interest and dividend payments for the soaring liabilities are going to have a real negative impact on potential GDP. This potential slow down could see loss of profits, national wealth and finally consumption. With the largest consumer in the world not buying imports, a global hole in trade will immerge, with follow on effects to other economies slowing down also due to loss of income. The slowing US economy will also cause potential investors to place their money else where, perpetuating the problem above.

Should the US government increase spending and tax cuts to stimulate the economy in the short run, a real rise in interest rates will cut private spending in order to fund the public debt which many foreigners are unwilling fund by poring more money into a slowing market. The long term effects include reduced GDP with increased liabilities.

The Consequences
Change in investment sentiment and lack of confidence in US financial markets.
Sooner or later there will be a drop in foreign investment towards the US. With the amount of people buying US dollars to invest in the economy falling, a reduction in demand for the currency will push its value down. Although a falling dollar isn’t necessarily a bad thing, as it will make US exports a more desirable commodity. They will have a global effect, with many currencies still pegged to the US dollar and many commodities such as oil also traded only in the US currency. Don’t think the US economy will come out unscathed either, both the depreciation of the dollar and lack of investment will have effects on national wealth, PPP, GDP growth, employment, interest rates, costs of production and in the end this will follow on to the rest of the world.

When investment starts to fall there are 2 strategies which can be employed.
•    Allow the exchange rate to depreciate naturally.
•    Reducing the supply of money to Increase Interest rates.

The exchange rate depreciates making US imports more expensive and their exports more desirable to the rest of the developed world. This change in consumption should stand to lower the trade deficit, but in doing so also reduces the US PPP as they are now unable to purchase the number of imports they desire, while much of the trade imbalances with China and other South East Asian with countries pegged exchange rate will stay the same. With the lower Asian currencies their export advantages will increase across the rest of the world. At the same time though, a lot of the raw material imports these countries need to manufacture their exports will increase in price, cause costs of production to rise, increasing inflation, reducing GDP growth and losing some of their competitive advantage with cheap labour costs.

The drop in the US dollar would also affect oil producing nations such as the Middle East and Russia. To counter this, OPEC may change the global oil currency from $US to Euros or Pounds Sterling, to ensure higher profits. If such action takes place US oil costs would skyrocket, increasing inflation, production and transport cost not seen since the oil crisis of the 70s. Such global effects could see the US economy almost halt with no savings, no foreign investment into businesses and sky rocketing production costs. Many business will go lay off staff who are too expensive and inefficient to hold onto, non essential purchase will stop reducing consumption and import levels, domestic investment will be fall with major confidence issues and due to the fact there will very little left over with increased inflation. And once the biggest consumer of the world resources and largest global importer stops spending, every nation around the world will feel the effects.

With a loss of income world wide, investment levels will fall, jobs will be lost and further consumption around the world will drop. Many countries will not feel the effects as hard as the US and China, but most will have a slow down in GDP. Should the above happen, China gets stuck with the decision to revalue/float their currency or to let it slide with the US. Should they keep it pegged, they will face similar oil price increases and the effects which follow. If they should increase the value of the Yuan their nation wealth will plummet with the huge surplus of assets and cash they currently hold in US dollars, as well as losing more export opportunities with its major trading partner.

Should the US Central Bank, try to stabilise the currency at its current equilibrium value by reducing supply as demand falls effectively increasing interest rates, the consequences are still far from ideal. An appreciation of interest rates should encourage the ‘bargain hunters’ to buy US securities and maintain a stabilised currency, but the reduction in money supply will soon follow on to Securities, causing much of the business and stock investments to dry up, reducing the value of money used in innovation and expansion. Less investment causes lower GDP and no need for job creation, potentially causing higher levels of unemployment and reduced consumption.

Increased interest and dividend payments.
As the CAD grows and larger sums of money are sent over seas in the form of dividends and interest payments, it increases the CAD further and gives more money to foreign investors to put back into the US capital market. This continual drain on finances should stop investment, but with the willingness of people to reinvest their earnings has meant that there has been no real drain on GDP. But what is happening is a wealth redistribution as foreigners gain the benefits of a strong US economy instead of the US public. This though is not all bad for the US, because the increased investment allows business to expand creating new job opportunities, which stimulates higher production and consumption.

Historically a widening CAD and capital liabilities have been major concerns with other countries because of exchange rate risks and because a lot was financed through debt, where the principle would have to be paid back eventually. The difference with the US, is much of the investment is equity financing and 95% of debt finance (bonds, bank loans etc) is in US dollars, so they have no exchange rate risk.

References
Bew R. (2005), "The Currency Crisis of 2006: It just Might Happen",  in Franklin D. (ed) The World in 2006, London: the Economist Magazine, p.136

Boltho A. (2004), “China – Can Rapid Economic Growth Continue?”, The Singapore Economic Review, 49 (2), 255-272

Bown C.P., Crowley M.A., McCulloch R. & Nakajima D.J. (2005), “The U.S. Trade Deficit: Made in China?”, Federal Reserve Bank of Chicago Economic Perspectives, 4th Quarter, 2-18.

Lee J.W., McKibbin, W.J. & Park Y.C. (2006), “Transpacific Trade Balances: Causes and Cures”, World Economy, 29(3), 281-303.

Macfarlane I.J. (2005), “What are the Global Imbalances?” Reserve Bank of Australia Bulletin, October, 19-27.

Mann C. L. (2002), “Perspectives on the U.S. Current Account Deficit and Sustainability”, Journal of Economic Perspectives, 16(3), 131-152.

William Poole (2005), “How Dangerous Is the U.S. Current Account Deficit?” Nov 9, 2005. http://stlouisfed.org/news/speeches/2005/11_09_05.htm
15 Oct 2007