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Dollar Pressure Points: Here’s what’s happening
National Review Online ^ | December 01, 2004 | Bruce Bartlett

Posted on 12/01/2004 11:42:47 AM PST by xsysmgr

For more than a year, I have been predicting — not advocating, just predicting — a significant tax increase to deal with the budget deficit. My hypothesis has been that sooner or later financial markets would put pressure on Congress to act on the budget deficit, and that the magnitude of the problem would be too great to deal with on the spending side alone.

I was unsure of where, when, or how this financial-market pressure would arise. But it now seems clear that it will come through the foreign exchange market. The dollar has been dropping rapidly and this is setting in motion forces that eventually will impact on domestic stock and bond markets. The possibility of a major crash cannot be ignored.

The root of the problem is the U.S. current account deficit, which includes the trade balance for goods and services, plus receipts on U.S. investments abroad minus payments to foreigners on their investments here. There is also a large negative figure for unilateral transfers abroad, such as those for military programs and foreign aid.

To show the orders of magnitude, in 2003 the U.S. exported $713 billion worth of goods and imported $1,261 billion, for a deficit of $548 billion. This was partially offset by a significant surplus in the export of services of $74 billion. U.S. companies also received more in income on their foreign operations than we paid out to foreigners on their operations here, giving us a surplus of $33 billion in this area. After subtracting $67 billion for unilateral transfers, we ended up with a current account deficit of $531 billion.

Basically, this $531 billion figure has to be financed by foreigners who are willing to invest in the U.S. directly or buy dollar-denominated assets such as stocks and bonds. In 2003, foreigners bought $829 billion worth of the latter, while Americans increased their ownership of foreign financial assets by $283 billion. The difference, $546 billion, approximately equals the current account deficit.

If foreigners were just interested in investing in the U.S. because they like our economic prospects and investment climate, this would not be a problem. Indeed, this unquestionably explains most of the private capital transfers. In places like Japan and Europe, economic prospects have been much worse than here for some time and investors there have had little choice except to invest abroad.

But lately, a considerable portion of foreign investment has been by foreign central banks in U.S. Treasury securities. From 1999 to 2003, these rose to $249 billion from $44 billion. The figure for this year will undoubtedly be higher than last year since foreign central bank purchases of Treasurys were already at $202 billion just through June.

As a consequence, foreign ownership of the U.S. national debt has risen to $1.8 trillion or half of the privately held debt. A decade ago, foreigners owned just over 20 percent of the debt.

The Japanese are the largest foreign holders of U.S. Treasury securities, with a total $720 billion in September, up from $317 billion just four years earlier. The Chinese have become the second largest holders, with $174 billion worth, a sharp increase from $62 billion in September 2000.

The reason for these large purchases of Treasury securities is that the Japanese and Chinese have been trying to prevent their currencies from rising against the dollar. They have done this by using their own currencies to buy dollars, which are then invested in Treasury securities.

The problem is that this process cannot go on indefinitely. It complicates monetary policy and threatens foreign central banks with large capital losses should U.S. interest rates rise. (Bond prices move in the opposite direction of interest rates.)

There is growing evidence that foreigners are getting weary of financing the U.S. budget deficit. The Chinese and Japanese are both talking about cutting back on Treasury purchases and diversifying more into euro-denominated assets. In order to continue selling its bonds, the Treasury will have to increase the interest rate it pays.

Some other consequences are that the dollar will fall further against foreign currencies, which will raise the prices we will have to pay for foreign goods. This will raise the inflation rate, which will encourage additional tightening of monetary policy by the Federal Reserve. A lower dollar will also make U.S. goods cheaper in terms of foreign currencies.

Most economists view this as a natural market process for resolving current-account imbalances. By raising the cost of foreign goods to us and lowering the cost of American goods to foreigners, it should reduce imports and increase exports.

The danger is that the dollar won’t fall gradually, but could drop precipitously, which could lead to a sharp drop in the stock market and a spike in interest rates in order to defend the dollar.

— Bruce Bartlett is senior fellow for the National Center for Policy Analysis. Write to him here.


TOPICS: Business/Economy; Editorial
KEYWORDS: currency; skyisfalling; taxes; trade
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To: RockinRight

This ignores the role of low interest rates in the determination of foreign exchange ratios. Nor does it discuss the term of the bonds/securities being bought. Short-term notes have no risk of capital loss due to rising rates since the time of maturity is short and they are paid off at face value when mature.

There is no way the dollar is not going to fall when interest rates are at the lowest point in decades.


21 posted on 12/01/2004 12:43:33 PM PST by justshutupandtakeit (Public Enemy #1, the RATmedia.)
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To: oldbrowser

The practice of exchanging dollars for gold (by foreign govs)was stopped in 71. Europe had been happily draining our reserve of its gold from the end of WW II until 1971. We are back up to 8000 tons in the reserve, while several European countries have been dumping, or are about to dump, gold into the market. Britain put nearly 395 tons, about half of their reserve, into the market two years ago. France plans to sell between 500 and 600 tons of the stuff over the next 5 years.

The dollar had been kept artificially high throughout the 90s, so this is the natural correction to that. The market is crying about our budget problems, and so buying Euros, all the while ignoring Europe's own massive budgetary woes. Eventually we will see a swing back the other way, especially if the Central Banks of Europe and Japan intervene to prop up the greenback.

Either way, I'm hedging my bets and putting money into metals to limit stock and bank exposure. Not too much, but just enough to balance any dollar losses.


22 posted on 12/01/2004 12:44:54 PM PST by ex 98C MI Dude (Proud Member of the Reagan Republicans)
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To: Moonman62

Trade deficits grow when the economy expands and shrink when it shrinks. Thus, we could tank the economy and have the strongest currency in the world. This is a reason the Euro is strong because the continent has unemployment rates about twice ours.

Collapsing the economy is not the way to go.


23 posted on 12/01/2004 12:50:56 PM PST by justshutupandtakeit (Public Enemy #1, the RATmedia.)
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To: oldbrowser

How would that be a problem given that we have not had a convertible currency for over three decades?

They can "ask" all they want but the answer will always be "no."


24 posted on 12/01/2004 12:52:42 PM PST by justshutupandtakeit (Public Enemy #1, the RATmedia.)
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To: Cicero
It's a very serious problem, but raising taxes will do absolutely nothing to solve it. I'm surprised that NRO would publish such garbage.

Bartlett is smart. He's saying that spending cuts are the best solution, but he knows that's not going to happen easily with a "no veto" president who has the worst government growth addiction since LBJ. Tax increases can work to solve this problem. They aren't desirable at all, but then he's a policy realist, and maybe he's trying to get someone's attention.

25 posted on 12/01/2004 12:53:36 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: ex 98C MI Dude

all the while ignoring Europe's own massive budgetary woes

Yes, let's not forget about that. I did not know about the
gold exchange, thanks for the analysis, I feel much better now.


26 posted on 12/01/2004 12:56:16 PM PST by oldbrowser (You lost the election.....................Get over it.)
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To: Moonman62
"They are very smart people and there is historical precedent for what they are saying (see 1987 stock market crash) Listen to them and understand. Do some research rather than calling them stupid."

Agreed.

There are, however, significant differences between now and 1987. September/October 1987 was a classic bubble. Go back and read some of Martin Zweig's stuff on the euphoria that was in place at the time. We are currently in a range bound stock market. Also, interest rates peaked just before the crash. If I recall, 30 year treasuries hit 10% the Thursday before black monday. There is no such spike in interest rates at the moment.

27 posted on 12/01/2004 12:58:32 PM PST by groanup (Rats are afraid of the light so spread a little sunshine.)
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To: justshutupandtakeit
Trade deficits grow when the economy expands and shrink when it shrinks. Thus, we could tank the economy and have the strongest currency in the world. This is a reason the Euro is strong because the continent has unemployment rates about twice ours. Collapsing the economy is not the way to go.

That's pretty much what Greenspan said on November 19th.

However, the Euro is strong for a couple of reasons. Their interest rates are too high and some countries have started to use it as a reserve currency. An economic boom can cause a trade deficit, but a stagnant economy is rarely the cause of a strong currency.

28 posted on 12/01/2004 1:06:23 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: all4one

They also increased their gold purchases by 25%. Keep in mind Russia just increased thier gold reserves by 5.5 billion in one week just before they announced possible restructure of us dollar reserves.


29 posted on 12/01/2004 1:07:11 PM PST by Fyscat
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To: justshutupandtakeit
"There is no way the dollar [Yen] is not going to fall when interest rates are at the lowest point in decades."

Perhaps interest rates aren't the best universal guide for falling currencies...

30 posted on 12/01/2004 1:07:23 PM PST by Southack (Media Bias means that Castro won't be punished for Cuban war crimes against Black Angolans in Africa)
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To: Moonman62

" but a stagnant economy is rarely the cause of a strong currency."

Thank you.


31 posted on 12/01/2004 1:08:59 PM PST by Fyscat
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To: Fyscat

Argentina has been snapping up gold as fast as they can, just like the Russians.

I'd like to see the Euro take over as the top reserve currency for a time. It would give us some room to stretch our economic legs. There are far too many dollars floating on the market right now, so a pullback would be a good thing. We have released (read printed) more paper currency into the market over the last 4 years than at any time from 1792 to 1980... combined. Thats a lot of dollars.


32 posted on 12/01/2004 1:13:15 PM PST by ex 98C MI Dude (Proud Member of the Reagan Republicans)
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To: groanup
There are, however, significant differences between now and 1987. September/October 1987 was a classic bubble. Go back and read some of Martin Zweig's stuff on the euphoria that was in place at the time. We are currently in a range bound stock market. Also, interest rates peaked just before the crash. If I recall, 30 year treasuries hit 10% the Thursday before black monday. There is no such spike in interest rates at the moment.

In that regard they are different for now (but we could be in a similar circumstance in the future). I'm referring to the weak dollar, and what can happen. We'd had a weak dollar policy since 1985's Plaza Accord. The week before the crash Greenspan gave an interview saying the dollar would have to continue to be weakened for many years to come (at least that's the way it was reported). That was the last interview Greenspan gave. He now gives speeches and testimony only.

Jimmy Carter also had a weak dollar policy that went too far. Rather than a crash, we had a significant continous decline.

33 posted on 12/01/2004 1:13:38 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: Cicero
"It's a very serious problem, but raising taxes will do absolutely nothing to solve it. I'm surprised that NRO would publish such garbage."

Small minded people tend to shout louder and more extreme things as they begin to realize that the masses are properly ignoring them.

Such people want attention, even if they have to make up reasons for people to listen.

34 posted on 12/01/2004 1:13:51 PM PST by Southack (Media Bias means that Castro won't be punished for Cuban war crimes against Black Angolans in Africa)
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To: groanup
Go back and read some of Martin Zweig's stuff on the euphoria that was in place at the time.

I remember Zweig back around 1997 was asked by uncle Lou on Wall Street Week about the cause of the 1987 crash. I think Zweig said there was no particular single cause after Lou asked him if it was portfolio insurance. I think Zweig was the only major figure that predicted the crash, thus his fame.

My contention isn't that Greenspan caused the crash, but he triggered it with his reported statement. After all, I don't believe he'd even taken office yet.

35 posted on 12/01/2004 1:34:59 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: Moonman62

A stagnant economy means fewer imports thus lower trade deficit and a higher currency.


36 posted on 12/01/2004 1:36:28 PM PST by justshutupandtakeit (Public Enemy #1, the RATmedia.)
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To: Southack
Small minded people tend to shout louder and more extreme things as they begin to realize that the masses are properly ignoring them.

LOL. I couldn't agree more. (back to ignore mode)

37 posted on 12/01/2004 1:38:00 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: Southack

Changes in interest rates are one of the principle causes of changes in demand for currency. If rates are falling demand for the home currency falls and its value versus foreign currency falls. The opposite occurs when rates rise. Raising our rates would slow the economy, reduce demand for imports and increase the demand for the dollar raising the price.

There are only a few variables which affect exchange rates and interests rates are as important as any. Or at least the differential between the domestic and foreign rates. Euro rates are high relative to the US thus the Euro rises.


38 posted on 12/01/2004 1:41:31 PM PST by justshutupandtakeit (Public Enemy #1, the RATmedia.)
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To: justshutupandtakeit
A stagnant economy means fewer imports thus lower trade deficit and a higher currency.

Is that the way it was in the 1970's? There are other factors that affect currency value than the trade deficit.

39 posted on 12/01/2004 1:41:44 PM PST by Moonman62 (Federal Creed: If it moves tax it. If it keeps moving regulate it. If it stops moving subsidize it.)
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To: Brilliant

Don't worry about the dollar. Let the EU worry about the dollar......

Great line echoing General Patton....let the other sumbitch die for his country.


40 posted on 12/01/2004 1:41:48 PM PST by bert (Don't Panic.....)
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