As foreigners abandon the dollar, is the US ready to change course?
US Has To Put Its Financial House In Order
We condense this article of November 29, 2007. The author, who graduated high school and college in Southern California and has an MBA from Columbia, is with Islamic Development Bank, Jeddah, teaches finance at Dar AlHekma College for Girls, in Jeddah, and appears on CNBC Arabia.
By Abdelmenem AddasWashington policymakers have placed the US economy in a dilemma. If the subprime mortgage meltdown worsens, low US interest rates will be required in order to contain the crisis. But if the dollar's plight worsens, high US interest rates will be required if foreigners are to continue to hold dollars and to finance US budget and trade deficits.
Forced to choose, Washington will raise rates in order to protect their ability to borrow. Without dollars from abroad, Washington cannot conduct its wars of aggression, and Americans cannot consume $800 billion dollars more each year than the economy produces.
The dollar's decline has resulted from foreigners accumulating new dollars at a lower rate. They still accumulate dollars, but fewer. As new dollars are still being produced at high rates, their value has dropped.
A few years ago the euro was worth 85 cents. Today it is worth $1.48. During the current administration the US dollar has lost 60% of its value against other traded currencies.
Foreigners who finance the US budget and trade deficits have experienced a huge drop in the value of their dollar holdings. The interest rate on US Treasury bonds does not come close to compensating them for the decline in the value of the dollar. Nor do investment returns from real estate and equities.
China holds over one trillion dollars. Japan almost one trillion, in dollar-denominated assets. Other countries have lesser but still substantial amounts.
Wall Street claims that foreign countries are locked into accumulating dollars in order to protect the value of their existing dollar holdings. Foreigners have continued to accumulate dollars in the expectation that sooner or later Washington would address its trade and budget deficits. However, now these deficits seem to have passed the point of no return.
By offshoring production for US markets, the US has no prospect of closing its trade deficit. The offshored production of US firms counts as imports when it returns to the US to be marketed. The more US production moves abroad, the less there is to export and the higher imports rise.
The situation may be even more dire. Recent work by Susan Houseman concludes that US statistical data systems, which were set in place prior to the development of offshoring, are counting some foreign production as part of US productivity and GDP growth, thus overstating the actual performance of the US economy.
In the 21st century, the US GDP has been driven by consumers going deeper in debt. Fed chairman Alan Greenspan's low interest rates triggered a housing boom, which created equity for consumers to borrow and spend. This source of US economic growth is exhausted and imploding.
If the huge bonuses paid to CEOs for offshoring their corporations' production and to Wall Street for marketing subprime derivatives are removed from income figures, Americans have experienced a decline in real income. Some studies, such as the Economic Mobility Project, find long-term declines in median incomes and upward mobility. A tax increase on flat incomes to close the budget deficit would cause widespread distress.
Japan and China, indeed, the entire world, realize that they cannot continue to give Americans real goods and services in exchange for depreciating paper dollars. China is endeavoring to turn its development inward and to rely on its potentially huge domestic market. Japan is pinning hopes on participating in Asia's economic development.
The reason the dollar has not completely collapsed is that there is no clear alternative as reserve currency. The euro is a currency without a country. It is the monetary unit of the European Union, but the countries of Europe have not surrendered their sovereignty to the EU. Moreover, the UK, a member of the EU, retains the British pound. The fact that a currency as politically exposed as the euro can rise in value so rapidly against the US dollar underscores the weakness of the US dollar.
If foreigners were to stop accumulating new dollars, the dollar's value would plummet. If foreigners were to reduce their existing holdings of dollars, the flood of dollars in America would inflate prices out of sight. The reign of the US as the economic superpower would end.
Part III, The Trouble With Money and its Cure
Iran Switch to Euros? Inconsequential!
Dollar Loses Favor with Drug Dealers
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