I recently returned from Europe, where the dollar just hit a new low against the euro. The European Union's new common currency, widely disparaged in Washington as a bizarre idea that would never win acceptance, was worth about 90 cents in 2002. Now it costs you $1.33 and is rising. The euro has emerged as a worldwide rival to the greenback. It makes the United States a bargain basement for visiting Europeans, while Europe is staggeringly expensive for Americans.
What ails the dollar? Two things. Our trade deficit grows bigger every year, as does our budget deficit. Both deficits require foreigners to supply capital. The more capital they have to supply, the more nervous they get about the dollar. Lately, private foreign investments in U.S. stocks and bonds have both declined, leaving the United States precariously dependent on two foreign central banks -- China and Japan -- to finance its twin deficits.
The U.S. trade deficit is now close to 6 percent a year and rising. In theory, a very cheap dollar should improve the trade balance by making exports cheap and imports expensive. But it doesn't work out that way. For one thing, many foreign producers, such as Japanese automakers, "price to market." That means that when the yen rises against the dollar, they just eat the cost in order to maintain their market share. So the dollar price of a Toyota doesn't change and the trade deficit doesn't improve.
China, meanwhile, keeps its currency pegged to the dollar, so a cheaper dollar doesn't improve our trade balance with the Chinese either. High oil prices also worsen the trade deficit. Most oil transactions are priced in dollars. As the dollar's value sinks, oil exporting nations just raise the price of oil.
By continuing to increase the federal budget deficit, most recently with a plan to privatize Social Security, the Bush administration only worsens the problem. And there is a growing risk of a financial meltdown with the following elements:
First, as foreign confidence in the dollar keeps shrinking, so does the dollar. The Federal Reserve then has to raise interest rates defensively to make investments in U.S. securities more attractive to foreigners.
But high interest rates slow U.S. economic growth, hurt the stock market, and could contribute to a long-anticipated crash of housing prices.
We could face a serious recession with no easy cure, since the usual fix is to run temporary deficits plus low interest rates. But in this case, overly large deficits were part of the problem, and higher interest rates would be necessary to prevent a further dollar collapse. But won't the Japanese and Chinese central banks, whose economies rely so heavily on exports to the United States, keep buying American bonds? Perhaps -- it's a kind of co-dependency in which they willingly buy paper that is losing its value because the exports help develop their real economies.
On the other hand, the United Staates is not just dependent on foreign central bank purchases of bonds. Because our budget deficit eats up so much domestic savings, our stock market and venture capital markets also are net borrowers from abroad. In the past we have counted on the fact that the American economy was so productive that foreigners, despite the trade deficit, saw the United States as a smart place to invest. But if the dollar is weak enough long enough, that investment starts drying up. U.S. financial markets have been quavering lately because foreign investment flows are dwindling.
How likely is this dire scenario? None other than Paul Volcker has said that he thinks that the odds of a dollar crash in the next few years are something like three in four.
The U.S. trade deficit has been a problem for more than a decade, but the responsible fiscal policies of the Clinton years helped moderate it and also led to a healthier dollar, which in turn allowed for lower interest rates. In this virtuous circle, we enjoyed a period of sustained and balanced growth.
What's remarkable about George W. Bush's immense deficits is how faint are the voices of fiscally conservative Republicans and business leaders. The Concord Coalition got immense publicity and respect during the deficit crisis of George Bush Sr. and provided crucial business support for Bill Clinton's efforts in 1993 to win a tax increase to reduce deficits. The coalition still exists, but you hardly ever hear of it. It's as if business is enjoying its tax cuts so much that the consequences be damned. It would not be the first time that short-sightedness by a selfish financial elite helped sink the U.S. economy.
Robert Kuttner is co-editor of The American Prospect. This column originally appeared in the Boston Globe.
