Dollar's Decline Is Reverberating
If foreign investors look elsewhere, interest rates could climb and living standards could fall.By David Streitfeld
Times Staff Writer
November 14, 2004
During a routine sale of U.S. Treasury bonds in early September, one of the essential pillars holding up the economy suddenly disappeared.
Foreigners have been regularly buying nearly half of all debt issued by the U.S. government. On Sept. 9, for the first time that anyone could remember, they stayed home.
"Thoughts of panic flickered out there," said Sadakichi Robbins, head of global fixed-income trading at Bank Julius Baer.
The foreigners returned in force at the next Treasury auction, and Sept. 9 was quickly dismissed as an aberration.
But the episode demonstrated how much the U.S. economy is dependent on other countries to bankroll its free-spending ways. That fragility is becoming even more precarious because of recent declines in the U.S. dollar to multiyear lows, some economists say.
Amid worries about bulging U.S. budget and trade deficits, the greenback dropped last week to a record low against the 5-year-old euro, a 12-year low against the Canadian dollar and a nine-year low against an index of major currencies. Many analysts don't see anything that will stop the decline.
A cheaper dollar reduces the value of American securities, making them less attractive to foreign investors. That could eventually precipitate what Robbins called "the doomsday scenario" — Japan and China not only refusing to buy U.S. bonds, but selling some of their $1.3 trillion in reserves.
The only way Uncle Sam could then find new customers for its IOUs would be by raising interest rates. And although higher rates are good for savers, they would be disastrous for a country weaned on cheap credit.
"Sometime soon, the falling dollar is going to show up in rising inflation, rising interest rates and a falling standard of living," said Harry Chernoff, an economist with Pathfinder Capital Advisors. "The housing and mortgage markets, which benefited the most from declining interest rates over the past few years, are likely to feel the most pain."
Not everyone agrees that suffering is imminent. The National Assn. of Manufacturers calls the dollar doomsayers "all but hysterical." Manufacturers and produce growers like a cheap dollar because it makes their products more affordable in foreign markets.
Even some foreigners like the low dollar. China has pegged its currency to the dollar. A weak greenback means a weak yuan, making Chinese goods cheaper in foreign markets and fueling the nation's economic boom.
To most American consumers, a falling dollar is more an annoyance than cause for alarm. It raises the price of a cup of coffee to outlandish levels during a Paris vacation, and may cause second thoughts about buying a more expensive Volkswagen.
But a number of economists and academics say there are real reasons for concern. If the dollar falls too far too quickly, they say, those all-important foreign investors will abandon the U.S. in favor of stabler places.
Indeed, there are signs that such an exodus might have already started.
In August, the most recent period for which there's data, foreign private investors sold $2 billion more in U.S. stocks than they bought, the Treasury said. Meanwhile, they dumped $4 billion more in government bonds than they purchased.
"A run for the exits could happen any day, that's for sure," said C. Fred Bergsten, author of "Dollar Overvaluation and the World Economy" and director of the Institute for International Economics, a Washington think tank.
Such a prospect creates a tricky balancing act for policy makers. As long as the dollar devalues in a slow and orderly way, and doesn't trigger panic selling of American securities, Bush administration officials appear to be comfortable with the fall. As they see it, the benefits of boosting the economy through higher exports outweigh the drawbacks.
The administration approach could work out fine in the short run, economists say. But eventually the slide must stop. Few countries can maintain strong economies with a debased currency.
Indeed, if a weak currency was the prescription for long-run economic health, countries like Argentina and Mexico — which have suffered massive currency devaluations in the last decade — would be financial titans.
Ultimately, these economists say, the solution is for the U.S. government to reduce its massive budget deficit. That would curb the need for Uncle Sam to issue so many Treasury notes. And the dollar would rise on its own, because the deficit is the main reason it continues to fall.
Having China decouple the yuan from the dollar also could help, economists say. It's a step the Bush administration has sought from Beijing, with little progress.
Under the best scenario, economist Bergsten sees China acceding to American pressure and easing or dropping the yuan-dollar peg by the end of the year.
Allowing the yuan to float upward would raise the price of Chinese goods in this country and reduce the U.S. trade deficit with the new Asian powerhouse, estimated to be $150 billion this year.
But if the Chinese resist, the euro will rise even further. It could move up from last week's $1.30 to $2, Bergsten said. Three years ago, it was worth 84 cents.
That ascent would upset the Europeans, whose exports would suffer and whose economies are already struggling. Central bankers usually speak in measured tones, but European Central Bank President Jean-Claude Trichet was moved last week to call the euro's rise "brutal" and "not welcome."
Neither the dollar nor the deficits became a hot-button issue during the presidential campaign, for obvious reasons. No politician has ever won an election by telling people their standard of living is going to go down, particularly at a moment when it's so easy to get a loan.
"The insidious thing about deficits is that they go on as long as the markets allow them to go on," said Maurice Obstfeld, an economics professor at UC Berkeley and author of many works on global capital markets.
"So people get lulled into the certainty they'll always be able to borrow at low rates, and that this is right and normal and an endorsement of their behavior," he said. "But it has to stop at some point."
A slump in the dollar also has been providing immediate benefits for some businesses, particularly multinationals but also smaller firms.
"There's all this scare stuff about the falling dollar, but it's allowing us to compete in the marketplace more effectively," said Stephanie Harkness, chief executive of Pacific Plastics & Engineering in Soquel, Calif.
Eighteen months ago, Pacific Plastics built a plant in Bangalore, India. It now employs 48 people there and 86 in Soquel.
"Our customers can save 50% when we produce molds for them in India rather than here," Harkness said. "My ideal scenario is not to have a plant in California at all."
If Pacific Plastics' bottom line is improving, the government's is steadily getting worse. The gap between what it spent and what it took in during the fiscal year that ended Sept. 30 was $413 billion, a record.
This week, Congress will have to raise the government's $7.4-trillion debt ceiling so it can borrow more money. According to the nonpartisan Congressional Budget Office, by 2008 nearly 10% of the budget will be devoted to interest payments.
President Bush has pledged to halve the deficit by 2008. Many economists say that will be difficult, if not impossible, without raising taxes, something Bush has pledged not to do.
In his postelection news conference, the president said the economy could grow its way out of trouble.
"As the revenue streams increase, coupled with fiscal discipline, you'll see the deficit shrinking," he said.
The stock market soared on Bush's remarks, but the currency markets rendered a different verdict. The dollar continued to fall.
It's not only the government that is profligate. The U.S. current account deficit — the broadest measure of international trade, including exports, imports, services and investments — rose in the second quarter to $166 billion, up 13% from the first quarter.
Much of the second-quarter shortfall was in goods: for every $20 in products American manufacturers sent overseas, U.S. consumers bought $36 in foreign electronics, cars and other items.
The current account deficit has risen from 1% of gross domestic product in 1990 to 5.4%.
That doesn't seem like much, and in the short term it isn't, said James Gipson, chairman of the $7-billion equity mutual fund Clipper Fund, in a letter to shareholders. But just like credit card debt, it compounds over the long term.
"A slowly and likely growing share of our output of goods and services will go to provide comfortable retirements for the residents of Tokyo, not Topeka," Gipson wrote.
One trouble with owners in Tokyo is that they may decide they want to own something in India or China instead.
That's why the Sept. 9 auction prompted concern.
Usually indirect bidders, which include foreign governments, are heavy buyers at Treasury auctions. This time, their purchases were less than 3%. Traders speculated that Japan was finally calling it quits.
What happened was never explained, but neither was it repeated.
"It turned out to be a fluke," said Kim Rupert, managing director for global fixed-income analysis at Action Economics, a consulting firm. "But at first blush, it was 'Oh my gosh.' "