Stephen King: Dollar's weakness is a concern for us all

Stephen King: Dollar's weakness is a concern for us all

Any other country that chose depreciation would be pilloried. It is not much more than a 'beggar-thy-neighbour' policy

22 November 2004

Do trade deficits matter? There are those who argue they don't. Many American policy makers have, in the past, taken the view that America's trade deficit is a sign of strength, not of weakness. For them, the trade deficit is an inevitable consequence of America's attractions as a home for international capital. The more that foreigners wish to accumulate US assets, the more that imports into the US will rise. If, for example, a Japanese car company decides to build a factory in the US, the required machines and equipment could be imported into the States from all over the world. US imports would rise, but only because everyone wants to invest there rather than elsewhere. That's good for American jobs, good for American incomes, and good for America in total.

This, though, is a remarkably blinkered view of the process that's taking place. It's true that, in the short term, an investment in the US rather than, say, Japan will create jobs in the US at Japan's expense. But the story clearly does not end there. By investing in the US, Japanese businesses (and their shareholders) are making claims on future profits made in the US. Those profits are not going to US workers. They are, instead, destined to end up in the pockets of foreign capitalists. To use the late Earl of Stockton's famous comment, the longer America runs a trade and current account deficit, the more of its family silver will end up heading abroad (or, at the very least, pawned in the hope that it will come back one day in the distant future).

America's current account deficit now stands at around 5 per cent of GDP. Its size is now becoming a real issue not only for financial markets but also for policy makers. The Federal Reserve has often worried about the sustainability of America's external finances, but those worries appear to have intensified in recent months. As Alan Greenspan remarked last week, there are "only limited indications that the large US current account deficit is meeting financing resistance. Yet, net claims against residents of the US cannot continue to increase forever in international portfolios at their recent pace."

The issue has hotted up for three key reasons. First, the structure of the US current account deficit is changing. Until recently, the deficit on trade was partly offset by a small surplus on net income from abroad. Initially, this seems a little odd because America's external assets are quite a lot smaller than its external liabilities. However, whether by judgement or good fortune, US investors have managed to extract higher returns on their foreign assets than foreign investors have achieved on their holdings of US assets.

This story, though, will not last. The sheer scale of the rise in external liabilities associated with a current account deficit in excess of 5 per cent of GDP tells us that, even if America were full of Warren Buffet clones, there's no way that the net income balance could help matters out. Indeed, now that this balance is also swinging into negative territory, the overall current account deficit is going to be rising at a faster and faster rate. If nothing else changes, the deficit will quickly head towards 8 or 9 per cent of GDP. Try funding that.

Second, the rapid growth of the current account deficit threatens the sustainability of American economic expansion. Should foreign investors prove unable to come up with the necessary funds to bail out the US in ever larger amounts, the US may find itself having to pay a significantly higher cost to get access to global capital. That could take the form either of a major increase in interest rates or, alternatively, a collapse in domestic asset prices. There's no guarantee that America won't avoid this fate but sensible policy makers will certainly want to explore other alternatives.

Third, those other alternatives have suddenly acquired a status wholly absent in previous years. The US Treasury Secretary, John Snow, has recognised the problem and wants to blame the Europeans for it. If only they'd buy a few more American goods, Snow suspects the problem would go away (a conclusion that reflects American frustration with the continued sluggishness of the European recovery: the irony, though, is that the flow of capital into the US that opened up the current account deficit in the first place was partly driven by Europe's sluggishness). And, importantly, the US now believes that the easiest way to deal with a possibly explosive current account deficit is to defuse the detonator via a weak dollar.

The remarkable thing for foreign investors is that the Americans have done the same thing on so many previous occasions. Since the demise of Bretton Woods in the early 1970s, the dollar has been a bit of a one-way bet. Admittedly, there have been numerous occasions when the dollar has been strong. The first half of the 1980s and the late 1990s are the two most obvious examples. These, though, are the exceptions that prove the general rule: when the going gets tough, the dollar gets falling.

Most debtor nations are ambivalent about currency depreciation. Obviously, a falling currency will help competitiveness. But it's also potentially a serious hindrance. Faced with heavy foreign currency liabilities, a depreciation or devaluation will increase the debt burden for those in the domestic economy who have borrowed from abroad. And, knowing that these debtors might struggle to repay their now higher debts, the risk premium tends to rise: in other words, a nation finds itself facing higher interest rates.

For the US, however, these arguments do not always apply. Because of America's reserve currency status, investors have been happy to lend to the US in dollars, not in their own currency. So, should the dollar decline, it's the foreign creditors that feel the pain, not the domestic debtors. This makes a dollar decline an unusually attractive option for US policy makers to pursue. Moreover, because so many other countries choose to peg their own currencies against the dollar - for them, it's a more credible nominal anchor than, for example, a domestic inflation target - any dollar decline requires them to buy dollar assets to prevent their currencies from appreciating. And that prevents the risk premium on US assets from rising very far.

It's easy to see, therefore, that dollar depreciation seems like a simple solution for America. Alan Greenspan also said last week that: "Alternative approaches to reducing our current account imbalance by reducing domestic investment or inducing recession to suppress consumption obviously are not constructive long term solutions." Fair enough, but any other country that chose depreciation instead of domestic adjustment - that passed the burden onto other countries - would be pilloried for making such a claim. At the end of the day, a dollar depreciation is not much more than a "beggar-thy-neighbour" policy.

And it's for that reason that perhaps we should worry. Periods of sustained dollar decline have never really been happy occasions for the world economy. In the early 1970s, when the dollar came unstuck following the collapse of Bretton Woods, inflation, exchange rate volatility and commodity price shocks became the major economic challenges, creating a nirvana for speculators but a nightmare for everyone else. In the late 1980s, the dollar's decline contributed to the stock market crash, Japan's economic excesses and the depth of the European recession in the early 1990s. A falling dollar might seem like a solution for the US but the longer-term consequences might prove to be quite a lot more painful for all concerned.

Stephen King is managing director of economics at HSBC
stephen.king@hsbcib.com