If the U.S. dollar is still a functioning currency after America’s two-decade-long borrowing binge, what’s to stop it from functioning forever? Well, for one thing, America is not alone in the world. Foreign investors have a say in the value of the dollar, and in the next few years they’re going to say some very unfortunate things.
As a major trading nation, the U.S. exports computers, software, movies, and food, among many other things. And it imports just about everything you can imagine. When the U.S. buys more than it sells, it makes up the difference-known as the trade deficit -by shipping dollars overseas. And in recent years it has been buying a lot more than it’s been selling. After averaging a manageable USD $80 billion annually during the 1980s, the trade deficit soared into the USD $300 billion range in the 1990s. And by 2003, this figure had exploded to over USD $500 billion. That’s about 5% of GDP, a level that, when it has occurred in other countries in the past, has preceded a sharp decline in the value of the local currency.
Why is America buying so much more than it’s selling? One reason is that it’s a lot cheaper to make most basic products in places like China, where smart, highly motivated people will work for about a tenth of the prevailing U.S. wage. So U.S. companies, in order to take advantage of this differential, are closing factories here and setting up new ones over there. Powerhouse discount-store chains, Wal-Mart especially, are driving the process by buying from a growing network of Chinese plants, passing some of the savings along to customers, and either driving competitors out of business or forcing them to buy from cheap foreign sources as well. As a result, low-wage foreign factories are now flooding the United States with incredibly cheap stuff, much of which used to be made in the States. And where not so long ago U.S. trade with China was more or less in balance, it now runs a deficit that exceeds USD $100 billion annually.
But the imbalance goes beyond just China. America is running annual deficits with Japan and the European Union of more than USD $100 billion and USD $50 billion, respectively. And of course, oil imports, mostly from the Middle East, seem headed nowhere but up. The inescapable conclusion is that U.S. consumers are addicted to a lifestyle that includes new cars, big houses, and slick electronic toys. And, as you know the U.S. is willing to borrow whatever it takes to avoid cutting back.
Looked at from virtually any angle, the U.S. trade situation is unprecedented. The annual trade deficit is larger than the budgets of Social Security and the military, and twice as big as Medicare. Since 1953, America’s manufacturing base has declined from 30% of GDP (when the U.S. had a trade surplus, by the way) to about 15% today. Since 1985, the cumulative deficit has grown to about USD $4 trillion, or about USD $13,000 for each man, woman, and child in the U.S.
What are America’s trading partners doing with these dollars? Their central banks have been accumulating huge piles of dollars as “reserves” to support their own currencies, while foreign businesses have been buying U.S. real estate, stocks, and bonds. Foreign investors now own about USD $8 trillion of U.S. financial assets, including 13% of all U.S. stocks, 24% of corporate bonds, 43% of Treasury bonds, and 14% of government agency debt. By the end of 2003, about a third of Fannie Mae’s mortgage-backed bonds were being sold outside the United States. In the 1980s, the U.S. was the world’s biggest creditor nation, meaning that we had far more invested in other countries than those countries had invested here. But by 2003, foreign investors owned USD $9.4 trillion of U.S. assets, while U.S. claims on the rest of the world were only USD $7.2 trillion. The United States is now the world’s biggest debtor nation.
This willingness of foreign investors to recycle their dollars back into the U.S. economy explains the dollar’s stability in the 1990s. And as long as they stay willing, the supply and demand for dollars will balance, and its stability will continue. But what if foreigners change their mind and decide not to buy U.S. assets? It seems that we’re about to find out. Foreign direct investment-that is, the dollar value of U.S. assets bought by foreign investors-fell from USD $300 billion in 2000 to USD $135 billion in 2001, and then to less than USD $100 billion in 2002 and 2003. And the dollar, suddenly, began to struggle. In 2003, it fell by about 20% versus the euro and yen, and by 30% versus gold.
But 2003 was just a warm-up. Though foreign investors recycled fewer dollars, they still bought USD $80 billion of U.S. assets and ended the year with a bigger stake in the U.S. economy than ever before. What happens if they decide to actually start selling their Treasury bonds or Manhattan real estate? In all probability, the dollar will weaken further, causing foreign investors to look elsewhere for opportunity, causing the demand for dollars to dry up. America will have a rout on it’s hands, and the debt problem will go from potential to very, very real.
One cause of the U.S. trade deficit is that Europe and Japan are growing more slowly and buying relatively little from abroad. Why the difference in spending patterns? Because they have serious problems of their own. Beginning with Europe, when France, Germany, and their neighbors replaced their national currencies with the euro, they laid down a few ground rules in an agreement known as the Maastricht Treaty. Among them was the requirement that no Eurozone country could run a deficit exceeding 3% of its GDP. But the treaty didn’t specify how they should achieve such fiscal prudence. It certainly didn’t force member countries to cut spending or adopt rational labour laws or business regulations. So Germany and France (again, following the standard currency script) kept their massive welfare states and debilitating regulatory regimes and simply hoped that a common currency would make their economies productive again.
It didn’t, of course. Both economies, hamstrung by bloated governments and high taxes, have been more or less in recession since 2000.
And their budget deficits are consistently above the Eurozone limits, which puts them at the same crossroad as the United States: They can either cut spending and live with the consequences, or they can continue to spend too much, run ever-higher deficits, and print however much ?at currency is needed to cover the difference.
By mid-2003 it was clear that they, like the United States, had chosen the second road. Though the 3% of GDP deficit limit is written into the Maastricht Treaty, French and German leaders dismissed it as a mere “symbol.” And both signalled that henceforth they would pursue growth rather than austerity. As one news account put it in July 2003, “The French appear to have seized on Germany’s difficulties to push for an overhaul of the pact, which they view as an obstacle to President Jacques Chirac’s spending plans.”
The European Central Bank, meanwhile, has been following the U.S. Federal Reserve’s lead, cutting interest rates to the lowest levels in decades.
Japan, the world’s second-biggest economy, has been mired in a slow-motion deflation since its real-estate and stock-market bubbles burst in the early 1990s.The culprit: massive bad debts on the books of major Japanese banks that no one seems to know what to do with. If the banks write them off, they’ll be left with too little capital to finance new loans, and whole sections of Japan’s construction and financial sectors, currently dependent on bank credit lines, will implode. If the banks allow the loans to fester, the country will continue to stagnate. In a vain attempt to kick-start the economy, the central bank of Japan has cut short-term interest rates all the way to zero-that’s right, loans cost nothing over there. And the Japanese government has tried one stimulus program after another, in the process accumulating a national debt that, as a percent of GDP, is more than that of the U.S. Now the government – whose credit quality has already been downgraded by the big debt-rating companies-is considering bailing out the country’s ailing banks by buying the bad loans, packaging them into bonds how the U.S. securitisation machine does this, and selling them on the global markets with some kind of government guarantee. And last but not least, the new Bank of Japan governor, Toshihiko Fukui, has suggested that he will, like the U.S. Federal Reserve, start buying longer-term Japanese bonds if necessary.
Japan also has a problem that’s the mirror image of the U.S. trade deficit. Because it runs a gargantuan trade surplus with the rest of the world, it has to manage a huge influx of dollars. It could simply let supply and demand work, which would result in the yen rising in value against the dollar. But that would hurt Japan’s exporters by making things priced in yen more expensive. And since exports are about the only thing that works for Japan right now, the country’s leaders are reluctant to let this happen. So the central bank has been buying dollars, thus accumulating a massive dollar-reserve position. To buy dollars they have to spend yen, which means they’re running their own printing presses out.
So here we are. The world’s major economies are all living far beyond their means and are borrowing to cover the difference. And they will, it now seems certain, continue to create as much new currency as it takes to delay the day of reckoning. The stage is set, in short, for a currency collapse a la Weimar Germany or 1990s Argentina, in which the world simply loses confidence in the dollar in particular and currencies in general. In such a “flight from currency,” the demand for dollars will dry up. The U.S. will spend it’s cash the minute it comes in, sending prices through the roof (in dollar terms). America will shun financial instruments, including bonds and many stocks, like the plague. And we will return en masse to the only money that is impervious to government mismanagement: gold.
for Markets and Money
Editor’s Note: James Turk has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics. He is the author of two books and several monographs and articles on money and banking. He is the co-author of The Coming Collapse of the Dollar (Doubleday, December 2004). In addition, James Turk is the Founder and Chairman of GoldMoney.com.