The value of the U.S. dollar has dropped more than 15 percent against the euro since February. That may not sound like a big deal -- a bit of bad news for American tourists this summer, a bit of good news for American manufacturers selling things abroad. But, in fact, it could be a sign that America's mounting foreign debt is about to deal a major blow to an economy already reeling from the shock of the dot-com meltdown and the crisis of U.S. corporate credibility.
In the last two months, warnings have come from Alan Greenspan, the world business press and the International Monetary Fund. Two Nobel Prizewinning economists have called America's growing foreign debt "the greatest potential danger facing the economy in the years to come." Neither the administration nor the Congress, however, has heard a thing.
The fundamental problem is that for the past quarter-century, we Americans have been spending more on imports than we have been earning from exports. And given our shop-till-we-drop culture, we do not save enough out of our national income to cover the difference. So in order to raise the money to buy their goods, we've been borrowing more from foreigners (by selling them American bonds) and selling them our assets (U.S. stocks and other property). The result has been a growing annual deficit in what's called the "current account" -- the net amount we owe to foreigners for goods, services, interest and dividends over what they owe us. By the end of last year, our accumulated current account deficits -- our total foreign debt -- amounted to 23 percent of our gross domestic product. Economists at Goldman Sachs predict that if we continue on our current trajectory, our foreign debt will amount to 40 percent of GDP by 2006. Like any enterprise whose debt payments are mounting faster than its income, we cannot go on like this.
Under normal circumstances, a country that runs a long-term trade deficit would see the value of its currency decline as the supply held by foreigners rose. The weaker currency would make exports cheaper, imports more expensive and investments less attractive, eventually bringing the nation's current account back into balance. But in our case, the dollar was in great demand for a long time, which kept its value from falling. Unlike other currencies, the dollar is widely used to pay for international transactions and as a reserve for central banks throughout the world. Even more important, in the 1990s the combination of a booming U.S. economy and turmoil in third-world markets made America a "safe haven" for foreign financiers, who were therefore willing to send their excess dollars -- earned from their U.S. sales -- back to us in the form of purchases of American bonds and stocks.
Only this year has it become apparent, as The Economist noted in April, that "there is a limit to the willingness of investors to hold ever more dollar assets." With the U.S. stock market crumbling amid worldwide skepticism about the honesty of our corporate accounting, the flow of foreign capital into this country has slowed dramatically. Even American investors are shifting from domestic to foreign investments. Accordingly, the dollar has slipped this year not only against the euro, but also -- by 4.5 percent -- against a combined index of the currencies of all the countries we trade with.
Unfortunately, the dollar still has so far to go that leaving the international rebalancing to take care of itself has become dangerous. Our current account deficit now runs about $400 billion a year, and the Goldman Sachs number crunchers estimate that just to cut that in half, the dollar would have to fall an "astonishing" 43 percent against the currencies of countries we trade with.
A dollar devaluation by anything near that amount -- unless we arrange to make it happen gradually, over a very long period of time -- would drop us into a deep and prolonged recession. Interest rates would skyrocket as investors demanded steep premiums to compensate for the risk that the value of dollar-denominated bonds might decline further. At the same time, prices would rise in every domestic market -- from apparel to computers -- that's now dominated by imports. Indeed, many products (TVs, for example) are no longer produced here at all. Thus, even with a dramatically lower dollar, it would take at least a decade to expand U.S. industrial capacity enough to rebalance the trade deficit.
And that's not all. Any reduction in the U.S. trade deficit means a reduction in the rest of the world's trade surplus with us. Given that economic growth in many countries now depends on sales to the U.S. market, it's hard to imagine that they would sit still for such a switch. Many are likely to resist by devaluing their own currencies or erecting new barriers against U.S. goods. Thus, in addition to a recession, we could end up with some very nasty trade wars.
In any event, U.S. influence in the world is bound to weaken as the dollar shrinks. Our expensive currency has allowed us to pay for foreign bases and other overseas costs of the war on terrorism on the cheap. Our appetite for low-priced imports, meanwhile, has enabled U.S. diplomats to win support abroad for American policies by offering or withholding access to the U.S. consumer market. A lower-priced dollar will make being the world's policeman more expensive.
Because our debt cannot grow faster than our income forever, a painful economic adjustment is at some point unavoidable. But the pain, for us and for the rest of the world, could be much less if we were to manage the dollar down gradually, in cooperation with the world's other major economies.
There's even precedent for such collective action. After Ronald Reagan's policies drove the dollar up in the mid-1980s, the cooperative intervention by the central banks of Europe and Japan eased the dollar back down by about 25 percent over three years.
It would also help if other countries would grow their domestic markets faster so they can buy more from us. It won't be easy to convince them. But in a global economy, our problem is also their problem. Better to enter now into discussions of how we will adjust rather than wait for the crisis to hit.
And certainly we should pause in our relentless drive to sign more trade-expansion agreements. At present, with every 1 percent rise in our national income, our trade deficit grows by 2 percent. Until we either curb our appetite for imports or become a lot better at exporting, the more we trade the deeper we go into hock.
But the chances that the Bushies will move in these directions -- steeped as this administration is in unilateral arrogance and laissez-faire ideology -- seem close to zero.
Treasury Secretary Paul O'Neill blithely dismisses the current account deficit as a "meaningless concept." (The Economist responded that the consequences of a declining dollar would bring sleepless nights to "a Treasury secretary who knew what he was talking about.") Nor do such worries furrow the brow of U.S. Trade Representative Robert Zoellick, the administration's Doctor Pangloss. Forget about imports, says Zoellick; look how our exports are rising! His approach is akin to measuring your personal solvency by adding up the deposits in your bank account and neglecting the withdrawals.
Most members of Congress seem equally clueless. In the heated debates over putting foreign-trade deals on a "fast track," our unsustainable trade deficit has been virtually ignored. When Sen. Byron Dorgan (D-N.D.) asked his colleagues what share of the GDP the trade deficit had to get to before they'd start to worry, the answer was dumb silence.
Dorgan says that both Republicans and New Democrats hear any talk of the trade deficit as criticism of free trade. And in Washington, so far, the divine right of multinational corporations to have access to the world's cheap labor trumps any concern for the resulting red ink. Our politicians' indifference to an out-of-control foreign debt is in striking contrast to their fretting about projections that the Social Security system might have to start borrowing money 40 years from now. On our present path, accumulating trade deficits will touch off a serious economic crisis long before the Social Security Trust Fund needs a modest tax increase to cover its obligations.
Mike Wessel, a former top aide to Rep. Richard Gephardt (D-Mo.), thinks that one reason politicians are avoiding the foreign-debt problem is that the solutions require too much heavy political lifting. "What politician wants to tell voters that they should be saving more and making fewer trips to the discount store to buy low-priced imports?" he asks. And, one might add, who in the Bush administration, after running roughshod over our allies in the war on terrorism, wants to go back to those same countries, hat in hand, to ask them to buy more of our goods and sell us less of theirs?
Thus, according to the Washington Consensus, it's better just to wait and hope that the inevitable dollar implosion will occur on someone else's watch. And who knows, maybe the laws of economics and human nature don't apply to America after all. Maybe we can continue to depend indefinitely upon the financial kindness of strangers. But don't bet on it. As the late Herb Stein, who was Richard Nixon's chief economist, once said: "If something can't continue forever it probably won't."