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Ominous: The US deficit vs the dollar
By Jack Crooks

"Doublethink means the power of holding two contradictory beliefs in one's mind simultaneously, and accepting both of them." - George Orwell

The US deficit is good, because it stimulates US demand and Asian exports. The deficit is bad because it has created a massive global financial imbalance that will one day need to be balanced. I think that qualifies as doublethink.

I am guilty of doublethink more often than I care to admit. But as I examine the financial "realities" and the implications of the US current-account deficit, the word "ominous" is the only thought that seeps into my mind. And though the timing is anyone's guess, the US dollar is poised to be overwhelmed by the deficit.

Peter G Peterson, chairman of the Council on Foreign Relations, the Institute of International Economics, and the Blackstone Group, had this to say in the September/October edition of Foreign Affairs magazine:
The United States is now borrowing about $540 billion per year from the rest of the world to pay for the overall deficit funding Americans' consumption of goods and services and US foreign transfers. This unprecedented current-account deficit is paid through direct lending and the net sales of US assets to foreign business or persons: everything from stocks and bonds to corporations and real estate. The United States imports roughly $4 billion of foreign capital each day, half of that to cover the current-account deficit and the other half to finance investments abroad. At 5.4% of GDP [gross domestic product] in the first quarter of 2004, the deficit is substantially higher than its previous record (3.5% of GDP) in 1987, when the dollar fell by a third and the stock market took its "Black Monday" plunge.

I think Peterson does an excellent job of explaining the deficit problem and its relationship to the dollar. The deficit truly is the common thread binding dollar bears. Here's a look at what they are seeing: 

The chart above shows the deficit rose to a whopping US$166.2 billion for the second quarter of 2004. Annualized, that's $664.8 billion, or approaching 6.5% of US gross domestic product. As bad as this seems, it will probably get worse before it gets better.

We are locked into a set of "daunting arithmetic", says Richard Berner, an economist with Morgan Stanley. He says, "The daunting arithmetic locks the current-account gap into a vicious circle that is hard to escape." Berner cites several reasons he thinks the deficit will get worse:
1) Imports of goods, services and income are 40% bigger than exports. And this ratio is on the rise again.
2) Higher US interest rates will increase debt payments to foreign debt holders.
3) Iraq war and redevelopment.
4) Slowdown in global growth, especially in Asia.
5) Soaring cost of imported oil.

Economics 101 teaches that if a country's currency depreciates, that depreciation will allow for an increase in exports, the theory being that the cost of its goods become cheaper, or more competitive, in international markets. But as one would expect, there is a lag time between the time a currency depreciates and its benefits begin to accrue in terms of trade. This means the deficit will first get worse then better as the currency declines in value. Economists refer to this as the J-curve.

Import prices rise immediately as a currency depreciates, but because the volume of trade is not as sensitive to price changes, it can take from one to two years for a positive impact to show up in the terms of trade and improving the current account.

Take a look at the chart above, which compares the US current account deficit to the trade-weighted US dollar from 1972 through the second quarter of 2004. I have tried to identify the last time the J-curve worked. It's represented by the rectangular area, highlighted on the chart. The dollar peaked in 1985 (red line). It then fell in value until 1988 before the current account deficit (blue line) began to improve. This also shows the fall in the dollar Peterson was referring to. Many believe it was a major catalyst for the 1987 stock-market crash.

Ominous parallels
"Economic history is utterly devoid of examples of current account adjustments that are not accompanied by significantly weaker currencies." - Stephen Roach, Morgan Stanley

I was thinking about the historical parallels in the economic environment now compared with then - during the time of the last dollar crisis. Here's what I came up with:



Go-go '60s stock-market boom (conglomerates craze) '90s stock-market boom (Internet craze)
Vietnam quagmire & communist dominoes Iraq quagmire & "war on terror"
Soaring budget deficit Soaring budget deficit
Rising energy prices Rising energy prices
Rising interest rates to stem inflation Rising interest rates to "normalize" the Fed funds rate
Soaring commodities prices (inflation driven) Rising commodities prices (for now, supply/demand imbalance)
But as bad as it seemed back then, the global financial system now appears much more unbalanced. The United States and China seem to be the sole economic engines of growth in the world. And the deficit is in historically uncharted territory and lurching from one fresh all-time record to another.

The dollar fell approximately 42% from its peak in 1985 to its trough in November of 1990 before the current-account balance turned positive again (when the deficit was 3.5% of GDP). This is the "adjustment" Roach is referring to. And it's why Roach believes a dollar crisis could "soon" be upon us.

From the peak in this cycle, February 2002, through September 2004, the dollar has fallen only 23%. The current account is now approaching twice what it was when it finally bottomed in 1988. So if we use the current-account "adjustment" as a guide, we should multiply the 42% decline by a factor of two to determine just how far the dollar must fall before solving the current-account problem - that's 84%!

It may seem silly to conceive of the world's reserve currency, the US dollar, falling that much. But if we consider there is little else on the horizon other than a fall in the dollar to help rebalance this situation, an 84% decline starts to look more plausible.

Chinese 'revaluation': That dog might not hunt
"In some ways, the 19th-century version of the global capitalist system was more stable than the current one. It had a single currency, gold; today there are three major currencies crashing against each other like continental plates." - George Soros, The Crisis of Global Capitalism

The three currencies Soros was referring to are the US dollar, the euro and the Japanese yen. And he is right. But the dollar's fate will probably flow one way or another from China.

Now that you understand how deeply the United States is entrenched in deficit, you can understand why the US is pressuring China to "revalue" its currency. The US does not have the political will to do what it takes on the spending side of the equation to improve its financial position.

"For the first time in the post-World War II era, the United States faces a future in which every major category of federal spending is projected to grow at least as fast as, or faster than, the economy for many years to come. That means not just pension and health-care benefits for retiring 'baby boomers', or increasing interest payments as deficits and interest rates rise, but also appropriated or 'discretionary' spending for national defense, for foreign aid, and for domestic homeland-security programs," writes Peterson.

In a country where voters know they can vote themselves the goodies and have accepted the term "war on terror", it's highly unlikely the US can get its fiscal side under control for many years to come. Thus the howls for China to do something with its currency grow louder.

There is one major problem with the Chinese "revaluation" scenario: There are no guarantees that once China allows the dollar-yuan rate to move within a "more flexible band" that its currency will appreciate against the dollar or that it will significantly benefit US manufacturers. Here are four reasons:

First of all, the chances of some type of big-bang revaluation in the dollar-yuan rate are slim to none. Chinese policymakers do not believe the yuan is overvalued. And I believe the most they will do is slightly widen the trading band around the 8.28-yuan-per-dollar rate that now exists.

Second, if China utilizes a trade-weighted approach to calculating its trading band, which is likely, because the US is the largest trading partner, and because said band will move on a trade-weighted value, not China's fundamentals, the index will not fluctuate a great deal against the dollar.

Third, it's not necessarily a differential in exchange rates that will solve the competitive differences between China's exports and the rest of the world. With China's abundant supply of very cheap labor, state-of-the-art manufacturing capabilities and world-class infrastructure, it will take much more than a shift in exchange rates before the goods flow comes into balance.

And finally, if financial liberalization includes reducing capital controls, the private sector has significant scope to raise its foreign-currency holdings (of US dollars).

US policymakers are depending heavily on a Chinese revaluation and a corresponding improvement in the balance of trade with China. But that dog might not hunt.

The dollar's Achilles' heel
"Causa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange - whatever it may be - back into cash." - Charles Kindleberger, Manias, Panics, and Crashes

Causa romota: An explosion of credit from bank lending and fixed investment pouring into China.

Causa proxima: A hard landing in China.

"When the Asian financial crisis hit in 1997-98, the US Federal Reserve tolerated a liquidity boom that spawned the Internet bubble. When the Internet bubble burst, the Fed tolerated another wave of liquidity, which has led to the global property bubble," says Andy Xie of Morgan Stanley. I would say, "Bingo!"

The Economist magazine recently summed it up this way: "China's boom is itself partly the product of the Fed's super-lax monetary policy. With its currency pegged to the dollar, China has been forced to import America's easy monetary conditions. Its [China's] higher interest rates have attracted large inflows of capital that have inflated domestic liquidity, encouraging excessive investment and bank lending in some sectors which could lead to a bust."

With the Fed now in a tightening mode, the music in China could soon end. And the scramble "back into cash" from "commodities, stocks, and real estate", as Kindleberger describes, could soon begin. When it does, it's very bad news for the buck.

When the US financial markets cratered in early 2000 after one of the biggest financial parties in the history of mankind, the Fed quickly stepped in to fill the void with liquidity. This is why the so-called "emergency" Fed funds rate of 1.0% materialized. The Fed made it clear to all it would err on the side of creating global asset bubbles in stocks, bonds and real estate to stave off the bogeyman of global deflation. Well, the Fed succeeded beyond anyone's wildest expectations at the time.

To get a sense of the massive liquidity created by the Fed, consider that Asian central banks are now sitting atop an estimated $2.2 trillion in foreign-exchange reserves - double their 2002 total. In other words, Asian banks were able to recycle $1.1 trillion into US Treasury bonds - driving yields lower and creating a virtuous circle for US consumers - increasing US demand for Asian exports.

As Treasury bonds soared and US demand rose, stocks revived. "It's the 1990s again," rattled the talking heads on CNBC. But the big winner in this liquidity game was global real estate. "The world is sitting on top one of the biggest property bubbles in history, with the biggest bits in China and the US, in my view," says Xie.

There is nothing new in what we are seeing in China. Massive lending funneled into property and commodities speculation: it's the classic boom-bust credit cycle. The late economist Ludwig von Mises wrote:

The drop in interest rates falsifies the businessman's calculation. Although the amount of capital goods available did not increase, the calculation employs figures that would be utilizable only if such an increase had taken place. The result of such calculations is therefore misleading. They make some projects appear profitable and realizable, which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins.
Artificially low interest rates in China have supercharged property speculation. Entrepreneurs, savers, overseas Chinese investors and international institutions have jumped into this "easy" money-making game. It's reminiscent of the "easy money" days trading the Nasdaq in 1999. The human frenzy and delusion are similar in tone.

Chinese government attempts to circumvent the price system through central planning/rationing, instead of market-based credit allocation through the interest rate, are exacerbating the boom-bust cycle in China. Inadvertently, they are sending the wrong messages to the market.

"The boom can last only as long as the credit expansion progresses at an ever-accelerated pace," wrote von Mises. Fed tightening is working its way through the global financial system. Soaring crude oil prices are dampening growth prospects. Property prices in Australia and the United Kingdom are already falling. And policymakers are continuing to apply the brakes in China where they can.

These are the dynamics that scream for an eventual bust in China. I believe this will be the catalyst for a dollar crisis. It could be a wake-up call to US policymakers. They may realize that ignorance is no longer strength when it comes to the deficit. But by the time they act, most of the damage will probably already be done. 

Timing it right

Here's an indicator that may help us with the timing of a fall in the dollar (taken from Black Swan Currency Currents, October 7):

US president Richard Nixon closed the gold window in 1971, severing the link between the dollar and gold once and for all. Robert Bartley, the now-deceased longtime editor of the Wall Street Journal and a brilliant man to boot, said when the dollar went off the gold standard crude oil went on the gold standard. He explained that the oil crisis in 1973 was in reality a foreign-exchange crisis (Money Bazaar, Andrew Krieger). In other words, the Organization of Petroleum Exporting Countries realized the dollars it was receiving for its crude oil was buying a lot less than it did before the gold link with the buck was severed. Thus it was time for a little price hike.

Okay, fast-forward. Oil is still priced in dollars and now at an all-time high, we all know that. But what is interesting is that the real cost of oil, if we consider gold to be the standard, is also close to an all-time high (calculated by the number of barrels of oil one ounce of gold will buy). This could have some implications for the greenback.

Let's say you are in control of the world's money supply. And you see that the cost of oil is threatening global economic growth. And let's also say that you keep an eye on gold prices because you once wrote a paper extolling the virtues of gold. And let us say your last name starts with the letter G. Okay, the stage is set. What do you do now?

Hmm, you're thinking: if I can somehow get the dollar price of gold to increase, it might take a lot of pressure off of the global economy by reducing the real cost of oil and clear the way for sustained economic growth. If you're thinking that, then you're thinking a weaker dollar.

Jack Crooks has traded in global equity, fixed income, commodity, and currency markets for more than 20 years. He is president of Black Swan Capital, a currency advisory firm -

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Oct 14, 2004
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