Dollar Pressure Points: Here’s what’s happening

National Review Online ^ | December 01, 2004 | Bruce Bartlett

[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.

[Moonman62]

Bartlett is a policy analyst. Keynes was right about deficits, but the government should promote investment and business activity, not demand. Manipulating currency is a zero sum game. For everything it gives it takes away, and often times it leads to loss of confidence in the currency. Trade balances are no problem as long as they result from differences in domestic growth between trading partners. The federal deficit is the real problem. If a Democrat was in the White House I'd probably get close to 100% agreement around here.

[Moonman62]

If the 1994 Republicans had any affect then they made the dollar fall further from 87 to an all time low of 79 in 1995. Right now the dollar is trading at 92. If we say a trading level of 92 is a crisis, then we have to call Gingrich's all time low a disaster. That wasn't and this isn't.

Huh? It isn't so much the absolute level as it is the rate of decline (or rise). Even your own chart shows that what happened after 1994 was nothing compared to the drop between 1985 and 1987, or the current drop. Besides if you want to talk about levels, go back to before 1973 and be honest about it.

[groanup]

"As to crashes look no farther back than Greenspan's rate hikes of 1999 and 2000. And before blaming all those crazy market players, please tell me you know what the Special Liquidity Facility was and how it affected the market. The stock market should never be attacked with monetary policy. The results were a disaster in 1929, 1999 in the US, and 1990 in Japan."

The Fed raised rates in 1994. I don't recall a crash. The Fed raised rates in 1989. I don't recall a crash. You need to read John Kenneth Galbraith's book: "A History of Financial Euphoria". It's all there. A bubble every 20-30 years and everyone has the same traits. Nobody sees it, nobody blames themselves but they blame everyone else. Somebody must PAY!

I just looked up the special liquidity facility. So what? Certain banks can pay over and above the discount window rate for money? Big deal. Have you ever been the officer at a bank who has to go to the discount window for money? It's like you are the heathen banker of the forest. They don't treat you very well. They don't cooperate with you at all. You'd BETTER have a real good reason and it'd better not be that your bank is going under.

[groanup]

"The federal deficit is the real problem. If a Democrat was in the White House I'd probably get close to 100% agreement around here."

I think you'll get 100% agreement around here that spending is out of control. The deficit is much, much lower than the norm in a time of war. And let's not even go to the "biggest deficit in history" crap. It isn't. You have to measure the deficit in terms of the balance sheet and the income statement.

[Moonman62]

I think you'll get 100% agreement around here that spending is out of control. The deficit is much, much lower than the norm in a time of war.

The military still only takes up about 4% of our GDP. It's nothing compared to WWII. Using the war as an excuse is the typical W apolegetics. GWB has a perfect "no veto" record. Something he also did as governor long before the War.

[groanup]

"sing the war as an excuse is the typical W apolegetics."

First of all I didn't use the war as an excuse. (Reading 101, see Spot run.) Secondly, I smell a liberal type debater here. You should try DU. They use tactics such as yours. You have ignored a lot of my questions and made up your own trickies to divert attention from my comments that you seem to have no answer for. I know your type well. I married into a family of them and I live in a city full of them. Remember the movie Arthur? "Don't screw with me Bert."

[Moonman62]

The Fed raised rates in 1994. I don't recall a crash. The Fed raised rates in 1989.

The Fed wasn't targeting the stock market either. That only happened in 1929 and 1999. In late 1999 and early 2000 it was already clear the economy was slowing on its own. Do you know why?

You might also want to look at price levels in 1989 and 1994. The situation was very different in 1999. The dollar was already very strong and commodities were making multi year lows. Raising the rates made no sense, unless he was attacking the stock market (though it still made no sense).

The Special Liquidity Facilty also had the promise that the Fed would buy all sorts of securities in order to keep the financial system afloat. Not only did it make the dollar a safe haven for Y2K but also stocks and and other financial instruments. I don't think it's a coincidence that the steepest part of the bubble occured as soon as the facility was announced (October 1999). Even though it didn't have to be used it had the effect of a gigantic rate cut.

[groanup]

"Do you know why?"

I most certainly don't and I am waiting for your blessed testimony. By the way, how do you know what the Fed is "targeting" at any point in time? I have personally known some of the pr economists on Wall Street who get paid millions to figure that out. I guess you could do it for, what, a couple a hundred a year? LOL!

[Moonman62]

I think you'll get 100% agreement around here that spending is out of control. The deficit is much, much lower than the norm in a time of war.

Right, you're not using the War as an excuse. I look at government spending as how much it really needs, not how much we can afford. Therefore, justifications as a percentage of GDP or any other measure mean nothing to me. GWB's no veto record tells me all I need to know.

I do grant that you are talking about the deficit and I recognize your point that we all pretty much agree that spending is out of control.

[groanup]

The Special Liquidity Facility was a last resort if zero interest rates couldn't stimulate the economy. The Fed would buy longer term securities from the banking system flushing cash through the system. At the time I thought it was incredibly open and forthright of the Fed to publicly announce this.

[groanup]

"GWB's no veto record tells me all I need to know."

I too am disquieted at the "no veto" record. At the same time I see a president who has openly stated that he is able to work with a republican congress to get legislation that they both can agree on. Think about it, he now has a Republican Congress, Senate and a GW Bush cabinet. If he can shrink, government, get a fair tax, win the war, and reform SS without a veto, GO FOR IT Mr. President.

[Moonman62]

I would tell you, but I'd have to charge you a couple of million for it. It's simple, the spending for Y2K remediation was over.

As to what Greenspan was targeting and why I gave you my reasons. It was pretty clear in his speeches too. There were two great evils, the "wealth effect" (his way of naming the stock market) and full employment. OK, I didn't mention that before, so you can only pay me $1.9 million. BTW, I don't care what you used to do or who you know and how much they get paid. Considering how the stock market bubbles up and crashes you all must be a bunch of overpaid idiots, or excellent con artists who went to the right schools.

[groanup]

"BTW, I don't care what you used to do or who you know and how much they get paid. Considering how the stock market bubbles up and crashes you all must be a bunch of overpaid idiots, or excellent con artists who went to the right schools."

Obviously you didn't go to the right schools, or any schools, and obviously you lost a pile of money in the 2000 crash and you want to blame it on everyone but the person responsible. Whatever, I have tried to be civil here but am not getting anywhere. Why am I even talking to you? Well, I'm not anymore.

[Moonman62]

You started by inferring that I was a liberal that belongs on DU. It doesn't get any worse than that in my book.

AMF

[groanup]

Stick a fork in it.

[snowsislander]

As a percentage of GDP, the "trade deficit" is nowhere near a record, same as for the "budget deficit."

What is your source for trade deficit versus GDP being worse than it is now?

I just did the calculations for the trade deficit versus the GDP from 1960 to 2003, and 2000-2003 were the worst four years in that time span, with 1987 and 1986 were fifth and sixth.

Here are my calculations:

Year    Nominal          Trade        Trade Balance 
        GDP in           Balance      versus
        $ billions       $ millions   GDP %
====    =======         =========     =====
1960	$526.40		$3,508.00	0.67%
1961	$544.70		$4,195.00	0.77%
1962	$585.60		$3,370.00	0.58%
1963	$617.70		$4,210.00	0.68%
1964	$663.60		$6,022.00	0.91%
1965	$719.10		$4,664.00	0.65%
1966	$787.80		$2,939.00	0.37%
1967	$832.60		$2,604.00	0.31%
1968	$910.00		  $250.00	0.03%
1969	$984.60		   $91.00	0.01%
1970	$1,038.00	$2,254.00	0.22%
1971	$1,127.00	-$1,302.00	-0.12%
1972	$1,238.00	-$5,443.00	-0.44%
1973	$1,382.00	$1,900.00	0.14%
1974	$1,500.00	-$4,293.00	-0.29%
1975	$1,638.00	$12,404.00	0.76%
1976	$1,825.00	-$6,082.00	-0.33%
1977	$2,030.00	-$27,246.00	-1.34%
1978	$2,294.00	-$29,763.00	-1.30%
1979	$2,563.00	-$24,565.00	-0.96%
1980	$2,789.00	-$19,407.00	-0.70%
1981	$3,128.00	-$16,172.00	-0.52%
1982	$3,255.00	-$24,156.00	-0.74%
1983	$3,536.00	-$57,767.00	-1.63%
1984	$3,933.00	-$109,072.00	-2.77%
1985	$4,220.00	-$121,880.00	-2.89%
1986	$4,462.00	-$138,538.00	-3.10%
1987	$4,739.00	-$151,684.00	-3.20%
1988	$5,103.00	-$114,566.00	-2.25%
1989	$5,484.00	-$93,141.00	-1.70%
1990	$5,803.00	-$80,864.00	-1.39%
1991	$5,995.00	-$31,135.00	-0.52%
1992	$6,337.00	-$39,093.00	-0.62%
1993	$6,657.00	-$70,195.00	-1.05%
1994	$7,072.00	-$98,379.00	-1.39%
1995	$7,397.00	-$96,265.00	-1.30%
1996	$7,816.00	-$103,942.00	-1.33%
1997	$8,304.00	-$108,178.00	-1.30%
1998	$8,747.00	-$164,868.00	-1.88%
1999	$9,268.00	-$263,252.00	-2.84%
2000	$9,817.00	-$378,344.00	-3.85%
2001	$10,100.00	-$362,692.00	-3.59%
2002	$10,480.00	-$421,735.00	-4.02%
2003	$10,980.00	-$496,508.00	-4.52%

Sources: GDP and trade .

[expat_panama]

Huh? It isn't so much the absolute level...

It's good that we agree that the present value of the dollar is not important.  

Let's work together on the "rate of decline (or rise)" with hard numbers and see if the facts warrant the use of the word "crisis".  The biggest drop in recent memory was '85.  No recession and low unemployment for years.  We finally had a slight recession in '90, after years of a level exchange.  Our next recession was in 2001 after several years of a strengthening dollar.

Let's be honest with each other.  I like hard numbers because I believe people (should) have power over their feelings-- but I know most people don't..  If you don't like numbers ("numbers don't lie but liars use numbers") you're in good company and we can leave it at that.