Critique Vol. XII, No. 2 (March, 2005)
Last Orders for the U.S. Dollar?
by Marshall Auerback


"Below the favorable surface [of the economy], there are as dangerous and intractable circumstances as I can remember. . . . Nothing in our experience is comparable . . . But no one is willing to understand [this] and do anything about it. . ."
"We are consuming . . . about six per cent more than we are producing. What holds the world together is a massive flow of capital from abroad . . . it’s what feeds our consumption binge . . . the United States economy is growing on the savings of the poor. . . . A big adjustment will inevitably become necessary, long before the social security surpluses disappear and the deficit explodes. . . . We are skating on increasingly thin ice."
Former Federal Reserve Chairman Paul Volcker (Remarks made at Stanford Institute for Economic Policy Research, Feb. 19, 2005)


“Last orders” is the cry one usually hears at closing time in an English pub. The beer spigots are turned off and the party’s over. One had a similar sense of finality for the U.S. dollar following the announcement on February 21, 2005, that the Korean central bank, which has some $200 billion in reserves, would “diversify the currencies in which it invests.” The dollar fell sharply and the U.S. market (although subsequently recovering) recorded its largest one-day fall in almost two years.

No doubt under considerable pressure from Washington, the Bank of Korea’s position was “clarified” within 24 hours. A BOK spokesman asserted that its desire to diversify its foreign exchange reserves was not new and did not mean it would sell the U.S. currency. The always reliable Bank of Japan was also wheeled in: “We have no plan to change the composition of currency holdings in the foreign reserves and we are not thinking about expanding our euro holdings,” Masatsugu Asakawa, director of the foreign exchange market division at the Ministry of Finance (MOF), told Reuters. Given the size of their respective holdings, both central banks would say that, wouldn’t they?

But first impressions are often very telling and probably more indicative of the BOK’s true feelings, coming as they did on the heels of warnings by the IMF’s Managing Director, Rodrigo Rato. Rato urged the U.S. to implement a credible set of policies to reduce its need for external financing before it exhausts the willingness of the world’s central banks to keep adding to their dollar reserves: “Record levels of debt are now financed by foreign investors and it is highly unlikely that such easy credit will continue to be available to the U.S. on the basis of the existing policy path.” One has a sense that the Koreans were echoing this message: “No more.”

That the mere threat of an Asian central bank diversifying its reserves out of U.S. dollars temporarily sent both the U.S. currency and stock market tumbling is truly indicative of the fragile state of the current financial system. In fact even the term “financial system” ought to be used guardedly here, since it implies that there is something orderly underlying today’s speculative global capital flows. In spite of the coordinated damage control by the Koreans and Japanese, it is very telling that the dollar did not swiftly regain its previous losses. The actions in the foreign exchange markets suggest that its participants (central bankers included) are coming to a belated recognition that something is truly amiss. It is certainly not a happy state of affairs when the dollar’s well-being is largely dependent on a handful of Asian central banks, which between them control almost $2.5 trillion in reserves and are beginning to become more public in their desire to hold fewer greenbacks.

The Bank of Korea, like every other major Asian central bank, faces the awful dilemma that confronts any large holder of an asset that is declining in value. They would like to diversify their reserves into other assets. To do so they have to sell dollars and buy, for example, more euros. But if they do that (and telegraph their intentions in advance), they risk pushing the dollar over the cliff, causing a huge loss in the value of their remaining dollar reserves. Financial instability would likely ensue, which explains why the Koreans beat a hasty retreat.

In spite of the spin doctoring, there is mounting evidence that the Asian central banks have already begun to lose confidence in the Federal Reserve’s ability to rein in U.S. financial and economic excess and are quietly acting accordingly. The Bank of China, for example, has given ample indications of its long-term intentions on this matter: roughly 50% of China’s growth in foreign exchange since 2001 has been placed into dollars. Last year, however, when China saw its reserves grow by $112 billion, the dollar portion of that was only 25%, or $25 billion, according to the always well-informed Montreal-based financial consultancy firm, Bank Credit Analyst. The Deputy Governor of the Bank of China has also signaled that “to ward off foreign exchange risks, China needs to readjust the current structure, increasing the proportion of the euro in its foreign exchange reserves.”
Even the Koreans, hitherto circumspect about their intentions (and likely to be even more so after February’s uproar), have in all probability merely followed China’s lead. A study by Stephen Englander of Barclays Capital Research indicates that unlike Japan, where the dollar share of reserves has risen over the past year, it appears that Korean foreign exchange reserves were approximately 80% US-dollar denominated before 2003, around 70% in 2003, and 60% or less by the end of last year. Englander’s judgment is based on estimates of how much the dollar value of Korean reserves moves up or down against other currencies. He deduces that the comparative lack of one-to-one correlation in the value of the reserves with the won-dollar exchange rate movements implies that as much as 45% of Korea’s substantial reserves may now be in non-dollar holdings. So the only real question is the extent to which the Koreans intend to continue this process.

Even if the Bank of Korea or the Bank of China were to desist from further selling their existing stock of dollars, this may only give the dollar a temporary reprieve, as it experienced in the first month of this year. U.S. private savings are clearly insufficient to fund the country’s growing current account deficit, so the dollar’s external value (and by extension, the bid in the bond market) is highly dependent on continued purchases by other central banks. If, as the Korean and Chinese actions suggest, these purchases begin to diminish further, in the absence of renewed foreign private sector inflows, the dollar will plunge.

It is not enough to argue, as economist Irwin Stelzer did recently in the London Sunday Times (“Falling Dollar and Rising Oil are a Dangerous Mix,” February 27, 2005), that the dangers of a falling dollar can be alleviated by the Asian central banks continuing to buy dollar assets “although at a slower pace and shifting to non-government bonds.” The U.S. position is such today that Asia’s central bankers must continue to increase their purchases of dollars simply to stabilize the dollar’s current value. Purchasing power parity does not come into play here. Debt trap dynamics do. That is to say, even if we make the generous assumption that the dollar’s recent depreciation in trade-weighted terms has ensured that the prices of U.S. goods are now cheap relative to its trading partners, it may well be irrelevant because as its overseas liabilities rise, the U.S. faces a deficit on its net overseas income that will further add to size of the current account deficit.

This is the essence of a recent piece of research by Stephen King of the Hongkong Shanghai Banking Corporation (The Ticking Time Bomb, HSBC, January 2005), who argues that as U.S. imports are so much larger than exports, exports would have to grow 5% faster than imports just in order to stabilize the trade deficit. The basic math suggests that the problem of a rising U.S. current account deficit will be with us for many years. On current trends, the U.S. will have net foreign liabilities equivalent to 90% of GDP and payments on overseas debt will reach 1.5% of GDP. In order to finance this deficit, King contends that Asian central banks would have to double the size of their dollar foreign exchange reserves. Reduced dollar purchases by central bankers, et al., as Stelzer suggests, are insufficient to restore a modicum of equilibrium to the dollar and financial markets.

But how many more dollars can Asia’s central banks buy? Current strains come against a backdrop in which, during the 15 months to the end of March 2004, the Bank of Japan acquired some $320bn worth of U.S. liabilities -- a sum equivalent to $2,500 per head of Japan’s population or more than three quarters of the U.S. federal deficit, according to Nouriel Roubini and Brad Setser (See: Will Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006, draft paper, February 2005).

It is possible that the U.S. could repudiate some of its debt, as it did in the 1930s (when FDR declared it illegal to own circulating gold coins, gold bullion, and gold certificates, thereby repudiating the government’s obligation to repay the country’s bond holders in “gold coin of the present standard of value”) or the during the 1970s (when President Nixon slammed shut the gold window and went off the last vestiges of the gold standard in 1971, in effect repudiating the remnants of the Bretton Woods system, which had governed the global economy throughout the entire post-war period)? One could make the case that the dire economic circumstances of the Great Depression or the stagflationary 1970s made these exceptional actions -- one-off generational events unlikely to be repeated in the more “normal” times of today. But as Paul Volcker recognizes, there is nothing normal about the current economic environment, in spite of Mr. Greenspan’s protestations to the contrary. If anything, the problems today may be even more severe.

At the time of the 1929 stock market crash, total U.S. credit was 176% of Gross Domestic Product. In 1933 with GDP imploding and the real value of debt rising even faster, total credit rose to 287% of what was left of GDP. (Irving Fisher, the economist who first explained the debt deflation of the Great Depression, described this process in which price deflation raises the real burden of debts even as firms and households shed assets and reduce expenditures in order to pay down debt. But these acts of liquidation by all economic agents push prices yet lower, which in turn raises the real debt burden further and caused further economic implosion.) In 2000, at the top of the late bull market, total credit was 269% of GDP. An extraordinary statistic to be sure, but dwarfed by today’s figure, in which total credit stands at a whopping 304% of GDP, according to a recent study by fund manager Trey Reik of Clapboard Hill Partners.

The obvious answer in such circumstances would be to restrain American consumption, but a Fisherian debt deflation dynamic is clearly in the cards if the U.S. truly seeks to get its economic house in order by leaving this to market forces alone. A world war was ultimately the means by which the U.S. economy emerged from the ravages of the Great Depression. But with the country already overstretched by current military operations (and possibly more to come in spite of President Bush’s protestations to the contrary), America’s “big stick” is looking decidedly eviscerated by woodworm.

The reason why more wars will not pull us out of the current financial hole is that the country is already so “imperially overstretched” that further conflicts will simply add to the ultimate tab. American taxpayers face not only record-breaking debt but record-breaking trade deficits, reduced government services, a crumbling and under-funded infrastructure, and three major public-sector programs – Social Security, Medicare and Medicaid – that are expected to double as a share of the economy, putting unimaginable pressure on tax rates, the economy, and the budget. And that’s before taking into account the financial burden of waging further faraway wars at a time when the country remains supremely reliant on the very foreign creditors who are becoming increasingly antagonized and alienated by the current thrust of American foreign policy. Are they likely to extend a further unlimited tab against such a backdrop? Would China, for example, now viewed again by the Bush administration as a “strategic competitor,” willingly continue to finance America’s growing deficits if such financing were used by the Pentagon to foment further instability and conflict in the Taiwan Straits?

The U.S. may well try to make the case that since it is doing the lion’s share in safeguarding the world’s global security from the threat of terrorism, the rest of the world could engage in a form of burden sharing by forgiving a large chunk of its debt. However, proposed negotiations along these lines are invariably undermined if Asia’s central banks continue to proclaim publicly their unwillingness to hold vast sums of U.S. dollars indefinitely, as the Bank of Korea did. America’s position is also not helped by the well-publicized dissemination of a recent meeting in Bangkok, in which Asia’s leading economic policy makers discussed, among other things, “global economic imbalances” and how to deal with the faltering dollar.
A former Federal Reserve Chairman, William McChesney Martin, once described the role of the institution he led as taking away the punch bowl when the party is really getting going. Clearly, Greenspan’s Fed is no longer willing to play that role (if it ever did). But it is increasingly dawning on the world’s markets that Asia’s central bankers may well have that role reluctantly forced on them, which explains the initial reaction to the Bank of Korea’s announcement. The positions of both the U.S. and Asia are becoming increasingly untenable. On current trends, America has embarked on a path that will exhaust the abilities of Asia’s central banks to hold increasing amounts of U.S. dollars; its recourse to military (as opposed to economic) suasion may simply make the problems worse. From Asia’s perspective, the Bank of Korea’s threat to reduce the share of dollars in its portfolio might simply represent the first of many “cris de coeur” from that part of the world that enough is enough. It may well be the case, therefore, that “last orders” are truly being placed for the U.S. dollar.

MARSHALL AUERBACK is a Denver-based international financial analyst who writes regularly for JPRI on economic and political developments in East Asia. His last article was “Will Japan Go Nuclear” (January 2005).

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