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Exchange rates by short run currency trading { February 2005 } Original Source Link: (May no longer be active)
http://www.businessweek.com/magazine/content/05_11/b3924034_mz007.htmhttp://www.businessweek.com/magazine/content/05_11/b3924034_mz007.htm
Bush's Worrisome Weak-Dollar Policy
Budget and trade deficits invite a dollar crash, followed by recession
ECONOMIC VIEWPOINT
By Robert Kuttner
MARCH 14, 2005
The gap between the Bush Administration's expansive geopolitical goals and its relinquishing of financial stewardship is becoming unsustainable. On Feb. 22 one line in a report by the Bank of Korea referring to diversification of its currency holdings away from the dollar created a brief panic in financial markets. While the markets have recovered -- for now -- it was a chilling reminder of the vulnerability of the dollar and the precarious position of the U.S.
The dollar is, of course, weak because the U.S. runs such huge trade and budget deficits. The federal government borrows nearly $2 billion a day abroad. Private foreign investors are unwilling to lend us that much money at current interest rates, so central banks make up the difference. In the first three quarters of 2004, fully 49% of the U.S. current account deficit was financed by foreign central banks, with Japan and China the lead lenders.
Japan and China are buying dollars to keep their currencies undervalued -- and their products underpriced. But this co-dependency creates a vicious cycle, with the cheaper Asian currencies and exports exacerbating the U.S. trade imbalance -- and necessitating still more borrowing.
CONSIDER THE IRONY: The Administration views America as the sole standing superpower based on our military might and our willingness to use it. But Bush's failure to address the U.S.'s growing reliance on foreign central banks creates systemic risks and economic dependencies inconsistent with superpower status. The Administration comforts itself by imagining that the financial relationship between the U.S. and its creditors is reciprocal and disconnected from geopolitical issues. Supposedly, none of the creditor nations would dare dump greenbacks because they would be cheapening the value of their own dollar holdings, undermining a key export market, and risking a global depression. Dream on.
The U.S. has vital diplomatic issues with each of its creditor nations. With China these range from arms sales to currency valuation to fair trade and differences over Taiwan and North Korea. China, a dictatorship that reigns over 1.3 billion souls, is also absent from Bush's global democracy agenda. Does Washington's financial dependence on China reduce our diplomatic leverage? Of course it does.
The Bush Administration is failing on three counts: First, mounting budget deficits increase the need for foreign borrowing and add to pressure on the dollar. Second, not having a serious energy policy intensifies U.S. dependence on imported oil and widens the trade deficit. And third, the Administration isn't even attempting to manage the dollar's decline, relying instead on the whims of money markets.
This contrasts markedly with the tenure of Ronald Reagan's Treasury Secretary, James A. Baker III. Although a staunch free-marketeer, Baker understood that exchange rates and interest rates are too important to leave to short-run currency trading. The Plaza Accord of 1985 produced coordinated interest-rate cuts and gradual depreciation of the dollar. When the pact fell apart in 1987, the stock market crashed.
A similar accord should have been on the agenda for Bush's Europe trip. Today, however, any attempt to work with other central bankers to manage an orderly dollar depreciation would require a commitment to reduce budget deficits, which the Administration is not prepared to make. Under Bush, international economic issues and officials dealing with them are distinctly second-tier. Treasury Secretary John W. Snow has neither the stature nor the authority that Baker enjoyed, and other key positions are vacant.
Some dollar decline is inevitable, but it needn't be calamitous. Bush's fiscal policy, however, virtually invites other central banks to reduce their dollar exposure -- and OPEC to move away from pricing oil in dollars. The Federal Reserve will increasingly find itself raising rates, not because inflation is worrisome but to defend the dollar. The Bank of England did much the same in the past century -- at a cost to Britain's long-term prosperity -- because imperial ambitions outran the nation's financial condition.
The worst-case scenario is a dollar crash, followed by a steep recession. The shame is that sensible policies, which the Administration won't pursue, could still head off a disaster.
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