In late January, the Senate confirmed John Snow as our new U.S. Treasury Secretary, the 73rd in the government agency’s two-hundred plus year history. Snow, like Paul O’Neill and Robert Rubin before him, promised to follow a strong dollar policy and take steps to help spur on a U.S. economic recovery and long-term growth.
Well, I know you’ve just started your new job, Mr. Snow, but I’ve got some sobering news for you. You and your pals can keep talking about this alleged “strong dollar policy” until you’re blue in the face, but it’s not going to make a lick of difference if you don’t start managing our currency more responsibly. The dollar is not just in decline; it’s a mess. If something isn’t done soon, I believe the dollar could lose its status as the world’s reserve currency and medium of exchange, something that would lead to a huge decline in the standard of living for U.S. citizens like nothing we’ve seen in nearly a century.
“Oh, Jim,” the disbelievers crow. “You’re just being extreme. That would never happen. After all, the dollar has reigned supreme for several decades”
True, but it seems to me that people forget that that supremacy isn’t a gimme. A sound currency, after all, reflects solid economic fundamentals: little to no debt, a trade surplus, a stable balance of payments—the difference between a nation’s receipts of foreign currency and its expenditures of foreign currency—and growing international reserves.
That’s not exactly the picture you get when you look at the U.S. balance sheet. Our national debt to foreigners is now around $6.4 trillion, with interest payments alone last year totaling $333 billion. We’re importing far more goods than we are exporting. International reserves remain around $60 billion, but we’re attracting far less direct foreign investment every year. Our current account deficit runs at roughly $500 billion a year, or five percent of our gross domestic product. Think of it this way: It costs us about $1.3 billion a day in the foreign markets just to keep the dollar afloat. Our $60 billion of reserves against our obligations would last 3 minutes if creditors begin cashing in. We’re like the untrustworthy brother-in-law who keeps borrowing money, promising to pay it back, but can never seem to get out of debt. Eventually, people cut that guy off.
As a result, the U.S. dollar continues to fall against its foreign counterparts, down 18 percent against the euro in 2002 and 10 percent against the yen. That’s not the worst it has been in history, but it’s certainly a substantial slide. With a war, a slow economic recovery and future threats of terrorism looming on the horizon , there’s little reason to believe things are going to improve.
What’s worse, little is being done by Washington’s economic gurus to pull us out of our economic quagmire. Faithful readers know I believe Alan Greenspan is the grand maestro of this economic debacle. Our esteemed Federal Reserve chairman is the first to “buy any assets” or lower interest rates to pump money into the economy and give investors the illusion that things aren’t as bad as they really are. Greenspan is ringing the bell signaling to sell dollars. Sometimes I wonder if our central bank is just going to print money until we run out of trees. People say that inflation is a dead issue, but you wouldn’t guess that shopping where most of us buy things or checking reality over on the commodity pages.
History teaches us that such imprudent monetary and fiscal behavior has always led to economic disaster. During the early 1920s, rampant inflation destroyed the value of German currency. German workers had to be paid twice a day just to survive; it took a wheelbarrow full of bills just to buy a loaf of bread. In England during the 1970s the government continued to boost its money supply, injecting its economy with liquidity, until debt levels spun out of control. Suddenly, no other countries would buy their sovereign bonds. Finally, the International Monetary Fund had to step in and bail the Brits out. Quite a shift for a country that only 50 years earlier was the single richest nation in the world. They lost their Empire during that time and endured currency controls for 40 years. Want a more current example? Just look south, to Argentina, where its currency recently lost so much value that the government prohibited its citizens from making withdrawals at the bank – or to several Asian “tigers” whose currencies collapsed in the 1990s or to Malaysia where in 1997 the government blamed everything on “evil foreigners” and blocked bank accounts.
So why doesn’t our government do something about our flagging currency? At least over the short-term, the declining value of the dollar does have its perks. A declining dollar is certainly good for domestic manufacturers who must compete with foreign companies. As the dollar drops, their manufacturing costs decline and it’s much easier for these companies to compete. The global economy is already sluggish, and the falling dollar makes U.S. exporters far more competitive. Again, it’s the illusion that things are better when they really are not.
Remember also: Our manufacturers may be better off, but foreigners then suffer so the world as a whole shows no improvement. That is why similar practices in the 1930s were known as “beggar thy neighbor”.
While this helps U.S. manufacturers, it’s not necessarily good news for consumers. The cost of imports, like foreign cars and foreign liquor, will rise. Since foreign goods become more expensive, U.S. companies may respond by raising their prices, even slightly, because they can. In the end, the dollar loses value, but we’re still paying the same real amount for many goods.
The bigger problem for the American economy is that foreign investors and foreign governments may soon lose their appetite for the declining U.S. dollar. Interest rates, which are now absurdly low, will need to rise to give foreign investors an incentive to invest and hold on to our currency. If not, these foreign governments and investors may look for somewhere else to hold their money. Historically, when investors recognize that a currency is being debased or devalued, they tend to look for sanctuary in currencies that remain stable at the insistence of the population. For years, the Swiss franc was synonymous with monetary stability.
While currencies like the Swiss franc or the Japanese yen or the Danish krone—all of which I own—are in better shape that the U.S. dollar, I don’t have a whole lot of confidence in them either. All of these countries’ governments have adopted the U.S.’s dangerous habit of manipulating their own currencies to compete in the world market. It’s a double-bind of sorts: Singapore’s government wants to keep its currency strong and sound, but if every other country’s currency is declining against the Singapore dollar, their exports become prohibitively expensive and it becomes impossible for them to compete. They are forced to play the monetary monopoly, shuffling the money supply, adjusting interest rates, just to make their products competitive.
And what about the Euro? It’s certainly stronger than the U.S. dollar, which is down 18 percent against the euro for 2002. I believe the success or failure of the Euro is one of the most important questions of the twenty-first century, one with profound implications on the global economy. The world needs the Euro, because it needs an alternative to the dollar. There really are only two currencies with enough liquidity to be the world’s currency—the U.S. dollar and the Japanese yen. (The Swiss may have a sound currency, but there just aren’t enough francs out there.) The European Union has everything going for it—an enormous population base, a balance of trade surplus. Most of its nations are creditors, not debtors. If the Euro succeeds, people may actually stop using the dollar as a medium of exchange and as a reserve currency.
That said, I believe that the euro is a flawed currency. Many of the European Union’s 12 member nations just don’t run a tight ship. Germany, which became the poster boy of fiscal responsibility in the mid-twentieth century, has again started running up huge debts. (Have they forgotten about the wheelbarrows?) The Portuguese are running an enormous deficit. The French recently said they are going to ignore the treaty establishing the euro. What’s going to happen when these countries can’t balance their books? Is Brussels going to send tanks into Lisbon? I doubt it. It may take years, even decades to root out all the problems in the EU’s inherently flawed system. Remember: Hundreds of billions of dollars (yes, dollars, for the moment) have been invested in this new currency. Banking systems have changed. Accounting systems have changed. Even parking meters have changed. If it fails or even struggles, there may be huge economic losses.
So by default, the issue of the euro is one of the world’s most important issues:  If it works, the replacement of the U.S. dollar as the world’s currency will surely impact us all.  If it fails, hundreds of billions will be lost.
In the meantime I actually own some euros because it is less flawed than the U.S. dollar.
How long does the dollar have? A year? A decade? I’m not so sure. As long as there’s no other currency stepping up to the plate and EU continues to struggle with the euro, the U.S. government will likely be able to continue to jiggle the books, essentially floating our enormous tab on the backs of the rest of the world. No country in history which has gotten itself into such a situation has escaped without at least a semi-crisis eventually.
But remember: Whenever there has been an economic crisis like this, a new player has always emerged on the economic landscape. A century ago, few people would have believed that the dollar was going to emerge out of the 19th century as the dominant world currency. There’s always a phoenix that rises from the ashes. Who will it be for the 21st century? My guess is the Chinese yuan may eventually have its day in the sun – certainly if the euro fails. The nation has a recipe for a sound currency—a huge population, an enormous balance of payments surplus, and a sizeable GDP to match. China is now the world’s largest importer and the world’s second largest creditor (Japanis first). For the moment, its currency is not convertible, which must change now that it has been admitted to the World Trade Organization. There are still a lot of cultural barriers to get over—rampant xenophobia and fear of capitalist interests—but nothing assuages fears like steady flows of money into your coffers.
Gresham’s law says that bad money tends to drive out good money. Well, whether we like it or not, whether we want to believe it or not, the U.S. dollar has become bad money. Despite proclamations from Washington about a strong dollar policy, I see no reason to believe that the dollar won’t continue to decline, that we won’t continue to borrow like beggars and put Band-Aids on gaping wounds in our fiscal, monetary and tax policies. That is, until the day when our creditors say enough is enough. And that day may not be far off.