Been to Europe lately? Expensive, isn't it? Prices in London or Paris these days are about double what they are in Washington or New York City. Not that long ago, people who like to mock the pretensions of the European Union thought it was pretty funny that its new single currency, the euro—created in part to challenge the dollar's global supremacy—had received such a thumbs-down from the currency markets. At its lowest value, in 2000, the euro would buy you just 82 cents. Lately, the euro has been trading at around $1.35. If this had happened all at once, you would be reading about the dollar's "collapse." If the exchange rate is a sign of strength—a global vote of confidence or no confidence in a nation's economy—Europe is apparently doing very well right now and the United States is in deepest trouble.
Well, the European Union does have lots of pretensions, and it certainly deserves to be mocked at every opportunity, but the exchange rate never was a straightforward vote of confidence. The dollar's strength a while back was not a good sign, plain and simple, for the United States, and its recent weakness is not a bad one. Things are a bit more complicated than that. Nonetheless, Americans ought to be paying closer attention to what is happening to their currency. The slide is happening for a reason, and it points to some real economic dangers.
The American economy is still growing faster than Europe's. Increasingly, in fact, the euro's strength against the dollar (which makes exports from the European Union, as well as hotel rooms in Paris, prohibitively expensive) is holding Europe's economies back. On other measures of economic health, such as the level of employment and the rate of job creation, the United States is also in better shape than the economies across the Atlantic are. But ever since the bursting of the dot-com bubble, the pattern of American economic growth has been weirdly skewed. And this is what is roiling the currency markets.
In a way, the currency is a victim of Alan Greenspan's success—and that of George W. Bush, too. The dot-com crash threatened the American economy with a bad recession. Greenspan responded with an extraordinarily bold monetary policy, cutting interest rates almost to zero. The idea was to buoy up demand in the economy, and it worked. Boy, how it worked. Consumers carried on spending as though the stock market crash had never happened and all those tech-stock dreams had come true. Borrowing at very low interest rates, courtesy of the Federal Reserve Board, consumers maxed out their credit cards and remortgaged their houses to release the equity.
Meanwhile, the Bush administration also put its shoulder to the reflationary wheel. It cut taxes—a lot—and it spent, and spent, and spent. The result was to turn an inherited budget surplus into a colossal budget deficit.
With consumers and the government borrowing as though tomorrow would never come, demand stayed strong—which was fine. That, after all, was the idea. The problem, however, was that all that borrowing had a counterpart in the economy's external accounts: a very large, and still growing, current-account deficit. Think of it this way. If everybody in America is a net borrower, whom are they borrowing from? All that's left is the rest of the world. So American demand sucked in imports. Loans from abroad—big- time—squared the books. At present, the U.S. current-account deficit stands at more than 5 percent of national output. According to recent forecasts, assuming no further change in exchange rates, this might rise to more than 6 percent of national output next year. Is that really so big? Absolutely. Almost any other economy borrowing that much would be regarded as teetering on the edge of bankruptcy.
What the dollar's decline shows is foreigners' growing reluctance to keep on financing that huge excess of demand over supply. Optimists about the dollar have always argued that the current-account deficit is not a concern, because it reflects foreign investors' confidence in the American economy—in its superior productivity growth and the prospects for higher returns. In other words, the inflow of capital comes first, and the current-account deficit changes to accommodate it. Pessimists tend to look at it the other way around: The current-account deficit is decided by the balance of supply and demand for goods and services; and flows of capital then adjust to accommodate that. The truth, of course, is that the two sides of the external accounts are determined at once: They have to match, but neither "causes" the other in the ordinary sense.
If Americans are to continue collectively consuming more than they produce, spending furiously and saving nothing, then foreigners must be happy to keep lending the country money; otherwise, the dollar will fall. Private lenders have already shied away. The days when American assets offered private foreign investors superior returns are over, at least for the time being. Long-term private capital—investment in real productive assets and in equities—is already flowing out of the country, in net terms. Short-term credit flows and lending by foreign central banks are now financing the whole of the external deficit.
Of these, purchases of dollar assets by foreign central banks are much the larger share. And in making those purchases, central banks, especially those in Asia, are guided not by calculations of the likely returns on American assets, but by the desire to peg their currencies and stop the dollar from falling. If their currencies appreciate against the dollar, their exports become less competitive. So they buy dollars, to hold their currencies down and prop the dollar up. That is not a vote of confidence in America—it is merely Asia's monetary strategy of export-led growth in action.
To be sure, it does not matter why those foreign central banks are lending so much to the United States, as long as they don't stop. But they will stop, eventually. It is only a question of when. As they pile up those dollar assets in the form of foreign-exchange reserves, they are increasingly aware that they are forgoing consumption and investment that they could otherwise be enjoying. And now that the dollar is sliding, the vast amounts held by those banks are losing value. If China and the others should start to sell those dollars—and to hold more of their reserves in the form of euros instead—the dollar's slide could quickly become a lot more dramatic.
America's economy is huge. As important as foreign trade may be to the United States these days, it still matters a lot less than it matters to a country like Britain. So the dollar can move a long way before Americans (especially those who do not take foreign holidays) get very agitated about it. In any case, the sustained and gradual fall in the dollar seen up to now is mostly welcome, because it improves the competitiveness of American exports and helps to boost foreign demand for the economy's output.
The trouble is, if the recent slide should turn into a rout, triggered by a move from dollars to euros by foreign central banks, or by a sudden acceleration of the private capital outflow, or both, the results would not be so pleasant, or so easy to ignore. The outlook for inflation would worsen as imports suddenly became much more expensive; long-term interest rates would most likely surge in anticipation of that; and, with the cost of credit going up, the mountainous debts that consumers have accumulated these past five years would start to look awfully heavy. If all this came about, America might very well get the recession that the Fed has succeeded in fending off thus far.
No matter what, the risk that events will unfold this way is not going to disappear—but the administration could and should lessen it. The simplest way would be for the government to borrow less. The White House continues to radiate blithe unconcern about the budget deficit—and about the dollar, for that matter. To the extent it acknowledges these global stresses, the administration puts the blame elsewhere. Europe should stimulate its economies, it says: That way, the Europeans would have faster growth, and increased American exports would reduce the current-account deficit. Japan, says the administration, could do the same. And China should stop pegging its currency too low.
All of this is true, in fact, but these things are not the main point. The principal cause of the global imbalances that threaten the American economy is America. The administration's studied inaction on public borrowing is weighing down the currency and increasing the danger of that much-delayed hard landing. Bush likes to live dangerously, that much is clear. Even so, he might come to regret taking the currency markets for granted.
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