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Dollar Drain - Can we remain a superpower with a collapsing currency?

Published 02/14/05 Paul Craig Roberts, former Secretary of the U.S. Treasury - Print Article
E-mail - editor@economyincisis.org

Editor's note: Our global dominance following World War II positioned the US dollar as the leading currency. As our leadership gives way to indebtedness, Paul Craig Roberts examines the result in February 2005.

Few Americans realize that their country's superpower status rests heavily on the dollar's role as the world's reserve currency. Shorn of its reserve currency role, The United States - with its massive trade and budget deficits, high indebtedness, declining currency, hollowed out manufacturing capability, and diplomatic isolation - would cut a poor figure in the world.

The dollar's role as reserve currency is jeopardized by the record growth of the U.S. trade deficit since 1990. Economists have not paid sufficient attention to this widening trade deficit, perhaps because they believe they heard it all before. The 1980s were replete with doom and glom about the "Reagan deficits." The Reagan economy continued on its merry way, however, and after rising for a few years, American trade deficits declined to insignificance.

Since 1990, however, our trade deficits have grown continuously, reaching $500 billion in 2003 and $600 billion in 2004. The excess of U.S. imports over exports between 1990 and 2004 has conveyed $3.3 trillion of U.S. equities (including entire companies), real estate, and government and corporate bonds into foreign ownership. Consequently, the income from these assets accrues to foreigners. As trade deficits mount, the share of American income paid to foreigners grows. Large and sustained trade deficits thus cause an explosive growth in our indebtedness to foreigners.

The outpouring of dollars resulting from U.S. imports, payments to foreigners from their American investments, and funds sent by immigrants to relatives in their homelands creates an enormous supply of dollars in foreign hands. Any other currency would have collapsed from oversupply. Being the reserve currency, however, the dollar is guaranteed a high level of demand. Foreign central banks keep their reserves in dollars, and oil-producing states bill their consumers in dollars, which requires other countries to exchange their currencies for dollars in order to pay for their oil imports.

The problem arises when foreigners perceive foreign claims in U.S. income to be rising faster than our gross domestic product. As the chart below shows, the U.S. trade deficit has been growing rapidly. During the past year, our cumulative trade deficit increased by $60 billion, or 22 percent. In 2003, the cumulative deficit increased by $500 billion, or by 23 percent. These obligations, which imply payouts, are growing more than five times faster than the U.S. economy. Foreign owners, like some American multinationals, are able to use accounting methods to understate their U.S. earnings for tax purposes, but the unsustainable growth in obligations is apparent from the chart.

The prospect of building up more claims to U.S. income than can be met results in a growing reluctance to hold more dollar assets. The depreciation of the dollar against gold, the euro, the Japanese yen, and the British pound reflects investors' efforts to protect their wealth from dollar decline. the past two years have seen reduced willingness by private investors to accumulate U.S. government bonds. It is foreign central banks, primarily in Japan and China, that are supporting the dollar by purchasing U.S. government bonds.

The question is how much longer Japan and China will add to their depreciating portfolios of U.S. government-issued bonds. Both countries support the dollar - China by pegging its currency to the dollar and Japan by exchange market intervention - in order to continue to gain American market share in goods and services. By keeping the dollar overvalued with respect to their own currencies, Japan and China have taken many jobs and much industry from America.

Japan and China's combined holdings of dollar investments are $1.5 trillion and rising. The dollar's decline of 70 percent against gold and 53 percent against the euro means that Japan and China are paying a high cost for their dollar holdings. At what point does this cost exceed the benefit of gaining or maintaining market share?

On Dec. 4, 2004, the New York Times reported that this question is worrying Masatsugu Asakawa, a top official in the Japanese Ministry of Finance who is responsible for managing Japan's $720 billion portfolio in U.S. government bonds. The Princeton-educated Asakawa says he been losing sleep over the dollar's fall. A 10 percent fall in the dollar reduces hi portfolio's real value by $72 billion. Asakawa sleeps with a currency monitor by his bedside that beeps him awake every time the dollar falls. Lately, that has been often.

Soaring U.S. borrowing from abroad also concerns the Chinese government. In a short period of time, China has acquired a stockpile of $600 billion. Recently, Chinese Prime Minister Wen Jiabao asked, "Shouldn't the relevant authorities be doing something about this [depreciating dollar]?" Japan and China's trade surpluses with the U.S. have become a two-edged sword for them. They delight in their share of U.S. markets but fear that the dollar's decline will eat up the value of their dollar holdings.

A popular explanation for Japan and China's willingness to accumulate dollars is that both countries are so deeply into dollars that they cannot afford to dump them. But the dollar is declining regardless. How long before a smaller Asian country decides it has had enough and sells off its dollar portfolio, or OPEC decides to bill oil in euros? Either action could start a run on the dollar that would be catastrophic for U.S. incomes and power.

To avert a crisis, the U.S. would have to increase its exports relative to imports by selling more abroad and buying less from other countries. Another piece of a confidence-building strategy would be to reduce the budget deficit, thus reducing the supply of new government bonds. Can we accomplish these essentials? Not in our present state of hubris and delusion. A country that sees itself as a superpower that can impose its will is unlikely to be aware of its peril.

U.S. imports are currently about 1.5 times higher than exports. Moreover, American produces are losing, not gaining, market share. Every time a U.S.-based company outsources goods and services, it turns domestic production into imports. Half of our trade deficit with China represents U.S. offshore production. Seventy percent of the goods on Wal-Mart's shelves are made in China. U.S. consumers are dependent on imported products. As imports rise with consumption, reducing imports means Americans must consume less.

Reducing the trade deficit by exporting more is also problematic. The U.S. has lost entire industries and technologies and is unable to close its trade deficit by increasing its share of world exports. Despite the jubilation over productivity growth, there has been no increase in America's share of world exports.

Having foolishly given away our education, agriculture, industry, and technology, we have no prospect of closing our massive trade deficit without a fall in incomes, whether absolute or relative to the rest of the world. The adjustment will come as a result of more dollar devaluation, rising import prices, and falling U.S. incomes due to the dollar's decline and job losses. The longer China is able to maintain its artificial currency peg to the dollar, the harder America's fall will be.

The dollar's value would strengthen if the federal government balanced its budget and if Americans consumed a smaller percentage of their incomes and saved more. But can the U.S. government restore budget balance while fighting wars, cutting taxes, and expanding spending? Unlikely. can Americans save more when they are loaded up with debt service and experiencing stagnant or falling real incomes? Unlikely.

Foreigners will not continue to lend to us at current interest rates. Interest rates will have to rise on U.S government bonds in order to compensate for the declining dollar, and when interest rates rise, what happens to construction. real-estate prices, and the indebted household holding variable-rate mortgages that have spent their home equity?

The dollar's sharp decline over the past year is evidence that the world realizes the U.S. trade deficits are unsustainable. The dollar's decline would have been even more dramatic if there had been an alternative in the wings to serve as reserve currency. The Japanese economy is large, but the Japanese government has made it clear it does not want the reserve currency role. The euro has come on the scene, but it is a political currency and unproven. The Chinese have pegged to the dollar in order to gain world market share. By irresponsibly wrecking the dollar, the U.S is leading the international financial system towards crisis.

Aware of the dollar's plight and the interest-rat implications, why have markets not moved U.S. interest rates higher? Low short-term rates can be explained by investors moving away from long-term bonds into money-market funds and short-term debt instruments in order to protect against capital losses from rising interest rates. Such a move should raise long-term interest rates. During President Bush's first year in office, however, the Treasury stopped issuing 30-year bonds. The reduction in supply offset reduced demand, leaving interest rates low.

It is harder to explain why lenders are accepting such low rates on 30-year mortgages. Perhaps the explanation is credit abundance from a Federal Reserve disarmed by low prices and minimal inflation resulting from offshore production. With near-zero interest rates in short-term markets, mortgages offer investors at least some income, but the risk of capital loss is high.

The over abundant supply of dollars has increased the risk of dollar-denominated investments, for both currency and interest-rate reasons. The real-estate market, bond market, and stock market are all vulnerable.

This vulnerability of wealth comes on top of the vulnerability of income. American jobs in tradable good and services are being sent abroad, and job growth is confined to domestic services that pay less than jobs that are outsourced. The ladders of upward mobility are being dismantled and the middle class is threatened. When the crisis comes, it will be political as well as economic.

The superficiality of American news reporting masks the threat to U.S. jobs. Seldom do reports delve beyond the aggregate new jobs figure released each month by the Bureau of Labor Statistics. The Jan. 7 announcement of December's 157,000 new jobs, although a lower figure than expected, sounds reassuring. But the real news is the composition of the jobs figure: the jobs being created are concentrated in state and local education, food services and bars, health care and social assistance, construction, administrative and waste services (mainly temporary help), and wholesale and retail trade.

Charles McMillion of MBG Information Services in Washington, D.C. has tabulated job growth and losses from January 2001 through December 2004. During President Bush's first term, the aggregate record is a net loss of 1,010,000 private-sector jobs - this over one year of recession followed by three years of "recovery." But the job losses in the tradable-goods sector are astounding. The manufacturing sector has lost 2,693,000 jobs. Employment in primary metals and fabricated metal products has declined by 23.6 percent and 14.2 percent respectively. Machinery production has lost 19.8 percent of its work force. Employment in computer and peripheral equipment, communications equipment, semiconductors and electronic components, and electrical equipment and appliances has fallen 29.3, 37.9, 36.7, and 23.4 percent respectively. Employment has declined 36.7 percent in textile mills and 41.9 percent in apparel.

These losses are extraordinary for a four-year period. They represent devastating reductions in skill and industrial capacity, and while feel-good armchair economists may attribute these jobs cuts to higher productivity, most reflect plant closings caused by offshore production and foreign competition.

The information and high-tech knowledge sectors that economists promised would take the place of the manufacturing sector in the "new economy" have failed to perform their assigned role. Since January 2001, the information sector has lost 547,000 jobs, with telecommunications being especially hard hit, and 102,000 jobs have left professional and business services. These losses are net losses from existing levels. They do not include jobs lost to Americans when U.S. firms outsources new jobs abroad.

Interest group and their spokesmen, who cloak themselves in free-trade rhetoric, cannot reconcile the dollar's collapse with their claim that the u.S. benefits from outsourcing and an open economy. If America benefits from globalism, shouldn't the dollar's strength reflect it? If there are mutual gains from free trade, why can't the U.S. economy create jobs in traded goods and services?

Outsourcing, offshore production for home markets, and rigged currency values are not included in the case for free trade. The free-trade case is based on the principle of comparative advantage, which carries two conditions: (1) the immobility of capital across national borders relative to traded goods, and (2) different internal cost rations of producing different goods in different countries.

Neither of these conditions holds in today's world. Capital and technology are as internationally mobile as traded goods. Modern production functions are based on acquired knowledge and result in identical cost rations regardless of location. Consequently, outsourcing and offshore production are based on absolute advantage, not on comparative advantage, and trade based on absolute advantage is not mutually beneficial to the well-being of the countries involved. Instead of mutual gains, there are winners and losers.

Economists cannot understand the present because they are lost in the past. The latest work in trade theory by Ralph E. Gomory and Willian J. Baumol demonstrates that there are inherent conflicts in international trade. Productivity gains always benefit the country experiencing them but do not always benefit that country's trading partners. developed countries can experience a decline in their well-being by transferring their capital and technology to less developed countries. Yet most economists continue to assume, mistakenly, that the U.S. benefits from transferring capital and technology to China and other parts of Asia.

Economists are secure in their delusion that America benefits from moving its economic capabilities offshore, just as neoconservatives are secure in their delusion of America's permanent superpower grandeur. Deluded people are incapable of dealing with crisis.

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