US privilege becomes even more exorbitant
Today's dollar jitters are no surprise; the few Keynesian economists left have long thought them overdue. Here's why:
· We have over many years worn down our trade position in the world economy, depending for our living standard on the willingness of the world to accept dollar assets - stocks, bonds and cash - in return for real goods and services.
· For decades the western world tolerated this "exorbitant privilege" of a dollar-reserve economy because the United States was the indispensable power, providing reliable security without intolerable violence. Those rationales evaporated 15 years ago.
· In the late 1990s, the US position was held up by the glamour of the information technology boom, which brought capital flooding in from more precarious perches in Russia, Asia and other parts of the world. But that too has turned to dust and ashes.
· The concentration of our manufactures trade on China and Japan now means that those two countries now hold preposterous dollar reserves, and their actions substantially determine the dollar's value.
· Chinese and Japanese behaviour is constrained by creditor's risk. If they sell too many dollars, the rest of their portfolio plummets and they inflict large losses on themselves. This consideration prompts caution. But if one major player gets wind that others may dump, caution could end. This is exactly analogous to an old-fashioned run on the bank.
Reducing the budget deficit will not save the dollar, contrary to what many Democrats may think. A bank, hit by a panic, cannot save itself by cutting its advertising budget, raising its fees or firing its staff. And once a rush gets going, jacking up interest rates won't stop it either.
So now we hear rumours of Russia trading dollars for euros, of India diversifying its reserves, of China contemplating the same. The Morgan Stanley economist Steven Roach apparently told clients to gird for an "economic Armageddon". The dyke, once solid, starts to crack; none can say just where or when it will break. But the little Dutch boy, Alan Greenspan, went to Frankfurt a few days back and plainly stated that he did not have enough fingers.
The most stunning aspect of these events has been Bush's insouciance. It's almost as if he realises the awful truth: that the dollar's decline is mainly good for his friends - and bad mainly for those about whom he couldn't care less.
The dollar's decline immediately boosts the stock market. Multinationals have earnings in the US and in Europe. When the dollar falls, US earnings stay the same but the European earnings go up when measured in dollars. Oil prices in dollars will stay up - at least enough to prevent the price in euros from falling. This too helps US oil company profits, measured in dollars.
Meanwhile, China will keep its yuan pegged, and prices of Chinese imports won't rise much, so Wal-Mart isn't badly hurt. American consumers get hit, but mainly on the oil price. Few will recognise the political roots of their problem.
Since the US owes its debts in dollars, pain will fall first on China and Japan. Tough. Latin American debtor countries will get hit on their exports, but helped on their debt service. Those (such as Mexico) who export almost exclusively to the US will get squeezed; others (such as Argentina) who market to Europe but pay interest in dollars will be hurt less.
An unequivocal loser is Europe, which hoped for an export-led fix to its own, largely self-inflicted, mass unemployment. The Europeans can forget about that.
It's possible that Alan Green span could change his mind, raise interest rates and inflict on us all the monumental folly of a "dollar defence". Sharply rising interest rates could cure both inflation and the weak dollar - as they did in the early 1980s. But the resulting slump would be even more disastrous than it was then, because debt levels are higher now.
I don't expect it. I bet Greenspan will take a pass on all the past decades of Federal Reserve myth-making. He will sit on his hands as oil and other import prices rise. Given the alternatives, it's probably the right course of action. But let no one say later, with a straight face, that our central bank takes seriously all its bunkum about fighting inflation.
Thus the dollar could decline smoothly for a while and then, simply, stop falling. US exports might recover somewhat, helping manufacturing, though there's no chance exports and imports will balance. But even so, the dollar system could stay intact, so long as China and Japan go on adding new dollars to their depreciated hoard.
A final panic could come later, set off perhaps by some new reckless military action. But for the moment, the theatre has too few exits, too few spectators.
Perhaps God really does look after children, small dogs and the United States.
· James K Galbraith teaches at the University of Texas at Austin, and is senior scholar at the Levy Economics Institute
(Monday December 6, 2004)