China and the dollar

“When will China finally realize that it cannot accumulate dollars forever? It already has more than $2 trillion. Do the Chinese really want to be sitting on $4 trillion in another five to 10 years? With the United States government staring at the long-term costs of the financial bailout, as well as inexorably rising entitlement costs, shouldn’t the Chinese worry about a repeat of Europe’s experience from the 1970’s?

During the 1950’s and 1960’s, Europeans amassed a huge stash of US Treasury bills in an effort to maintain fixed exchange-rate pegs, much as China has done today. Unfortunately, the purchasing power of Europe’s dollars shriveled during the 1970’s, when the costs of waging the Vietnam War and a surge in oil prices ultimately contributed to a calamitous rise in inflation.

Perhaps the Chinese should not worry. After all, the world leaders who just gathered at the G20 summit in Pittsburgh said that they would take every measure to prevent such a thing from happening again. …

The fact that world leaders recognize that global imbalances are a huge problem is welcome news. Many economists, including myself, believe that America’s thirst for foreign capital to finance its consumption binge played a critical role in the build-up of the crisis. …
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With the US government currently tapping financial markets for a whopping 12% of national income (roughly $1.5 trillion), foreign borrowing would be off the scale but for a sudden surge in US consumer and corporate savings. For the time being, America’s private sector is running a surplus that is sufficient to fund roughly 75% of the government’s voracious appetite. But how long will US private sector thrift last?

As the economy normalizes, consumption and investment will resume. When they do – and assuming that the government does not suddenly tighten its belt (it has no credible plan to do so) – there is every likelihood that America’s appetite for foreign cash will surge again.
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Chinese leaders clearly realize that their hoard of T-Bills is a problem. Otherwise, they would not be calling so publicly for the International Monetary Fund to advance an alternative to the dollar as a global currency.

They are right to worry. A dollar crisis is not around the corner, but it is certainly a huge risk over the next five to 10 years.”

Kenneth Rogoff, “China’s dollar problem”, Project Syndicate (10 October 2009).

http://www.project-syndicate.org/commentary/rogoff61


Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University. He was formerly chief economist at the IMF.


The Chinese should worry.

The dollar has been trending downward on foreign exchange markets for more than seven years, and since early 2002 has lost 25 per cent of its value in relation to a basket of currencies including the euro, the pound sterling, the yen, and the Canadian dollar. It has also had its ups and downs. Early in 2008 the dollar hit an all time low, then bounced back a bit and is now sinking once again. The rise since its low point has not been particularly strong and now another downward drift seems underway. Given its recent unsteadiness a plunge below its 2008 low may well be before us.

The dollar has been decline for a simple reason. The U.S. has been sending out too many dollars for too many years and the world is flooded with them.

Until the recent financial crisis, the decline of the dollar abroad was rooted in persistent overconsumption and undersaving at home, reflected in a decades-long export of a huge volume of domestic currency in return for an import of foreign saving that indirectly financed the consumption binge of increasingly overweight, constantly whining and ever more self-absorbed Americans. (Yours truly in the lead.) This showed up in a massive trade deficit that reached 6 per cent of the GDP and left the country heavily in debt to foreigners.

The American consumption binge was aggravated by public policy. Many decades of relatively low interest rates and high marginal tax rates increasingly depleted the prospective pool of domestically-generated investment funds and decades-long fiddling around with the tax and regulatory codes to promote consumption (write-offs for mortgage interest, health insurance, education costs and a host of other consumer expenditures, plus a long list of regulations whose sole purpose is to increase artificially access to consumer credit to unqualified buyers, such as mortgages for sub-prime borrowers) left the country dependent upon foreigners to finance the investment its overconsumption would not allow.

Adding to the problem has been the increased use of foreign financing to cover deficits in U.S. government accounts, especially the past year. The U.S. is now heavily in debt abroad and there is an increasing unwillingness on the part of foreigners to hold more greenbacks. While American saving has risen, this is because of a greatly depressed level of economic activity and a retrenchment in spending by consumers. It is unlikely to continue, at least at its present rates, once the employment recovers.

Even if consumption remains subdued, the dollar is likely to continue to fall. And as the dollar falls, foreigners can be expected to rebel against holding more increasingly worthless Federal Reserve notes and other government paper and they will be loath to take on any more dollar-denominated debt. China and other buyers of U.S. Treasuries have made that clear. The days of the strong dollar and the ability of the U.S. to borrow abroad without limit are over.

Not everyone in the U.S. seems aware of the changed position of the U.S. on international financial markets. The Congress in particular seems oblivious to the perception by many here and abroad that the country simply cannot continue to accumulate debt at the rate it has in the past. The health care reform bill now being discussed in the Congress provides an example of domestic actions that may have international repercussions. Despite assurances to the contrary by politicians, all of the health care reform bills currently under discussion in the House and the Senate will add greatly to budget deficits that are already out-of-control . No one is fooled by what politicians say and everyone understands that the money to finance many of its provisions will have to be borrowed abroad, mainly from China.

Even if the Americans do not seem to be worried about their accumulating debt, foreigners are. They know that any increase in external borrowing will further erode the value of the dollar.

Rogoff believes a dollar crisis is not around the corner.

I am not so sanguine.