[Mb-civic] Buttonwood Dollars Demise

Wed Nov 24 10:36:08 PST 2004

Buttonwood 

The dollar¹s demise

Nov 23rd 2004 
>From The Economist Global Agenda

Is the dollar¹s role as the world¹s reserve currency drawing to a close?

Get article background

WHO believes in a strong dollar? Robert Rubin, Bill Clinton¹s treasury
secretary, most certainly did. John Snow, his successor but two, says he
does but nobody believes him‹if only because he wants other countries¹
currencies, in particular the Chinese yuan, to go up. Mr Snow¹s boss,
President George Bush, in one of his mercifully rare forays into economics
last week, also said he wants a muscular currency: ³My nation is committed
to a strong dollar.² Again, it would be fair to say that this was not taken
as a ringing endorsement. ³Bush¹s strong-dollar policy is, in practical
terms, to maintain a pool of fools to buy it all the way down,² a fund
manager was quoted by Bloomberg news agency as saying. It does not help when
the chairman of your central bank, Alan Greenspan, whose utterances on the
economy are taken rather more seriously than Mr Bush¹s, has said the day
before that the dollar seems likely to fall: ³Given the size of the
current-account deficit, a diminished appetite for adding to dollar balances
must occur at some point,² were his exact words. The foreign-exchange market
immediately decided that it was sated, and the dollar fell to another record
low against the euro.

 Mr Greenspan¹s words were of huge moment, and not just because he spoke
clearly, unusual though this was, nor because the Federal Reserve rarely
comments on foreign-exchange movements. No, Mr Greenspan¹s words were
significant because he was tacitly admitting what right-thinking economists
the world over have long believed: that the emperor has no clothes.

Mr Greenspan¹s previous line had been that America¹s ever-expanding
current-account deficit was not a problem when capital could flow so freely
around the world; and that, in effect, it would continue to flow to America
because the country is such a wonderful place in which to invest. Now he is
saying that it won¹t, or at least that investors will demand a cheaper
dollar, or cheaper assets, or both, to carry on financing America¹s deficit.

But Buttonwood suspects that the deeper significance of Mr Greenspan¹s
admission is that the game that has been played since the collapse of the
Bretton Woods system in the early 1970s is drawing to a close. The dollar¹s
status as the world¹s reserve currency‹its preferred store of value, if you
will‹is gradually coming to an end. And, ironically, the fact that it has
become so popular in recent years will only hasten its demise.

One man who undoubtedly believes in a strong dollar is Japan¹s prime
minister, Junichiro Koizumi. Unlike America, Japan has been putting its
money where its leader¹s mouth is. On behalf of the finance ministry, the
Bank of Japan has bought more dollars than any other central bank has ever
done. At last count, it had the equivalent of $820 billion in
foreign-exchange reserves, most of it denominated in the American currency.

As goes Japan, so goes the rest of Asia. In an interview this week with the
Financial Times, Li Ruogu, the deputy governor of China¹s central bank, the
People¹s Bank of China, said that his country would not be rushed into
revaluing the yuan, and that America should put its own shop in order. Mr
Ruogu¹s bank, too, has been a huge buyer of dollars in recent years. China
and the rest of developing Asia now have $1.4 trillion of reserves, mostly
dollars. This is more than the combined reserves of the rest of the world
(excluding Japan). Thanks mostly to Asian intervention, foreign-exchange
reserves at the world¹s central banks have climbed from $2 trillion in 2000
to $3.5 trillion in 2004.

 It used to be that countries amassed reserves as a war chest to protect
against a run on their currencies of the sort suffered by East Asia in 1997,
or Russia in 1998. But Asian countries have snaffled up far more than would
be justified to prevent such crises. Their aim in accumulating these
reserves is generally different now: to stop their currencies rising against
the dollar and so keep their exports competitive. In effect, they are trying
to peg their currencies; China¹s peg is explicit. Huge foreign-exchange
reserves are the result.

Some pundits have dubbed this arrangement the new Bretton Woods. The Bretton
Woods arrangement (a post-second world war agreement that tied the dollar to
gold and other currencies to the dollar) collapsed in 1971. The present
arrangement seems similarly doomed to failure. The big question is whether
the world will suffer similarly ill effects when it collapses.

Past saving?

The upward pressure on Asian countries¹ currencies stems either from their
saving too much and consuming too little, or from America saving too little
and spending too much. American politicians, naturally, tend to concentrate
on the first interpretation, because it stops them having to recommend
unpleasant remedies, such as cutting deficits or encouraging Americans to
save more. But Mr Greenspan¹s most recent comments show that he recognises
the problem is more home-grown. Personal saving in America, as a percentage
of household income, slumped to just 0.2% in September, close to a record
low. Indeed, the savings rate has been declining remorselessly since 1981,
when it reached a high of 12.5%. This lack of saving shows up in the
current-account deficit, which is a record near-6% of GDP and rising.

In effect, foreigners are saving on America¹s behalf. In a recent study for
the New York Fed, two economists, Matthew Higgins and Thomas Klitgaard,
point out that the United States now absorbs more than the measured net
saving of the rest of the world combined (suggesting someone¹s got their
figures wrong somewhere). The American economy cannot continue to expand at
its current rate without those foreign savings. The question is whether
foreigners will be happy to carry on financing this growth with the dollar
and asset prices at their present level. The private sector is already
voting with its wallet: it has been financing an ever smaller percentage of
the deficit, and there has been a net outflow of direct investment. That
leaves the public sector‹ie, central banks‹and those, in particular, of
Asia.

At the heart of the central banks¹ calculations is a trade-off: intervening
to keep your currency down can be costly, but it is good for exports. Though
the costs of intervention are hard to quantify, they are potentially big.
Because the domestic money supply is expanded‹those dollars must be paid for
with something‹it can cause inflation (though this can be neutralised
through ³sterilisation², ie, bond sales). But the big potential cost is in
amassing a huge stash of dollars with precious little exit strategy. Quite
simply, Asian central banks now own too many of them to exit en masse, for
their exit would cause the dollar to crash and American interest rates to
soar, which would cause huge losses on their holdings of Treasuries.

 Get out while you can

The biggest risk, of course, is that lenders would lose pots of money were
the dollar to fall. As the printer of the world¹s reserve currency, America
can pass on foreign-exchange risk to the lenders because, unlike other
indebted countries, it can borrow in its own currency. Messrs Higgins and
Klitgaard reckon that for Singapore, the most extreme example, a 10%
appreciation against the dollar and other reserve currencies would lead to a
currency capital loss of 10% of GDP. Though loading up with even more
dollars might of course stop the dollar from falling for a while, it would
increase the risk of still larger losses were it eventually to do so.
America already needs almost $2 billion a day from abroad to finance its
spending habits, and the situation deteriorates by the week because America
imports more than it exports, which worsens the current-account deficit.

The incentives to flee the Asian cartel (to give it its proper name) thus
increase the bigger the game becomes. Why take the risk that another central
bank will leave you carrying the can? Better to get out early. Because the
game is thus so unstable it will come to an end, and probably a messy one.
And what will then happen to the dollar? It is hard to imagine its hegemony
remaining unchallenged when so many will have lost so much. And doubly so
given that America has abused the dollar¹s reserve-currency role so
egregiously that its finances now look more like those of a banana republic
than an economic superpower.

Send comments on this article to Buttonwood (Please state whether you are
happy for your comments to be published)

 Read more Buttonwood columns at www.economist.com/buttonwood