(In honor of the "For Dummies" and "Idiot's Guide" series of books, I am inaugurating a new "For Complete Morons" series of articles, which I hope you will find enjoyable, educational and mostly correct.)
Several items of economic note occurred in the last couple of months that provide a lesson of sorts on international monetary economics:
- The dollar reached an all-time low against the euro as central banks around the world shift currency reserves from the US dollar to euros. (See FT article)
- The US debt as a percentage of our income (GDP) is approaching record levels not seen since World War II. (See graph)
- The producer prices index (PPI) jumped 0.8% in February, the highest such jump in six years, which led to sharp falls in stock prices on the day of the announcement. (See Reuters article)
- The 2004 trade deficit was reported, and it is the highest ever, not just in dollar terms ($617.7 billion), but more importantly, as a percentage of Gross Domestic Product, or GDP (5.3%). The US set record trade deficits against Canada, Mexico, China, Japan, the European Union and South and Central America. Even during the heady spending days of the Reagan-Bush years of the 80s and early 90s, the trade deficit crept above 3% of GDP in only two of twelve years.
What does this mean and why should you care?
If you have an adjustable rate mortgage, money in mutual funds, a long commute or SUV, or dollars sitting in a bank account, you might want to care. First the basics: Economics is governed by supply and demand. Few empty seats at the concert and scalpers can charge whatever they want; lots of empty seats and good luck selling your extra tickets for face value. The same applies to stock prices: If people decide they want Apple stock and don't want Yahoo stock, Apple stock price will rise on increased demand while Yahoo stock price will decline as people sell it off. Fine. Basic stuff.
You can think of money in the same way: If demand for dollars grows relative to supply, then the value of the dollar will increase (appreciate) against other currencies. Similarly a decline in demand for dollars will cause the dollar to decrease (depreciate) in value. If you think of the U.S. dollar as Yahoo stock and the euro as Apple stock, we can understand better why the euro has climbed so high and continues to climb against the dollar. Investors are cashing out of dollars and investing in euros and other currencies.
One reason people sell the stock of one company (or in this case, one country) is because they think (or fear others will think) it is
poorly managed. If Yahoo's debts were growing year after year, while Apple was actually accumulating profits, you might make the switch too. So let's look at the management of the US versus Europe. In 2003 and 2004, the US government budget deficit was about 5% of GDP (GDP is Gross Domestic Product, which is akin to the "earnings" of a country). For the same period, the EU ran government deficits of less than 3%. It's true, deficits can be a good thing. I ran a deficit to get a law degree, and it is somewhat paying off. I know people who borrowed to buy real estate, and it has paid off for them too. So if Apple runs a deficit (borrows money) to update its technology or finance a new product or expansion project or train its employees, that might produce greater income (GDP) in the end. But what if the spending is not on a house or an education, but on lavish meals, a brand new car and electronics, war, medical care for 35,000 permanently maimed soldiers, and to finance US consumer credit spending, government deficits and the like -- items that are not considered investment? You get the picture. In short, if the investor, in this case the world, decides we are investing wisely, it will stay invested in the dollar; otherwise it will sell.
Each business day, the US must attract about $2 billion in net lending and investments to fund our deficit spending. The people lending us dollars to finance our debt have these extras dollars to lend because of our trade deficit (known as the current account). More dollars leave the United States to pay for imports than we collect from our exports. Those extra dollars abroad circulate back to the US by way of foreign investment in US t-bills, stocks, bonds, etc. Which may be fine, if we don't mind more and more of our assets being held overseas and the possibility of a sell off of those assets, and if those dollars go to investment, versus wasteful spending. (
Warren Buffet warned that Americans may end up a "Sharecropper Society" if we maintain our current path -- paying a large portion of what we earn to foreign owners.)
Another reason foreign holders might wish to sell dollars is that there is a
viable diversification alternative. Today, the EU has the same size economy as the US (each is about $11 trillion), which is growing at the same 1.8% (factoring out the effects of population growth) as the US's. The EU is slated to pick up some Eastern European countries with growth rates far exceeding the US's. An Ernst & Young survey of international businesses showed a preference for investing in new projects in Western Europe (38%) over Central and Eastern Europe (19%), China (16%) and North America (14%). This does not bode well for dollar demand. In the 18th and 19th centuries, the currency of choice was the British pound. But with the decline of Great Britain as a world power and the rise of the United States, the world shifted to dollars. Having your currency widely used gives you the power to dictate many of the terms of the international system. For example, oil contracts anywhere in the world are denominated in dollars and many government and foreign investors hold large dollars reserves (although euro reserves have been growing as a percentage of all reserves). A move to euros could signal a weakening of American influence in the world, as happened with Great Britain at the end of the 19th century. In any case, there is nothing like competition to give the frontrunner a run for its money (no pun intended).
So back to things you care about, like your adjustable rate mortgage, mutual funds, a long commute or dollars buried in the mattress (or bank). The dollars is the easy one. This is like holding Yahoo stock while everyone else is selling and the price declines. If the world sells off its dollars, then as the dollar depreciates, you become poorer in world terms.
Because the US finances its deficits by borrowing money abroad (i.e., selling t-bills) and paying interest on those borrowings, if the rest of the world starts to sell off dollars, then the US will have to raise interest rates to make the dollar investment more attractive. It's like adding a second headliner to that empty concert to attract concertgoers, or increasing the dividend on a stock or interest rate on a corporate bond. But paying higher interest rates (1) causes the deficit to grow even faster since more interest must be paid out of the budget, and (2) if the government is paying more on its borrowing, why should a lender lend to someone buying a house when the lender can lend to the government. . . unless that rate goes up too, and it does. Rising interest rates make it harder for people to buy homes and start businesses and this in turn depresses the demand for homes and home prices and slows economic output.
Your commute? Remember that we are net importers of oil and gas. Even though oil contracts are denominated in dollars, a devaluing dollar will make oil and gas prices climb even higher. In fact the falling dollar is largely responsible for driving the price of oil to record highs. Because energy is a major input in our domestic economy, this price increase could have a ripple effect, causing a general increase in the price level -- inflation. (So far there are only a few signs of inflation, but remember that jump in the PPI number.) And since we import so many of our goods, those prices will increase as the dollar weakens, and that too creates inflation. (There is a slight offsetting feature to the devaluing dollar: our exports should become cheaper and increase in number, but this in turn is offset by the fact that much of our exports rely on imported, and hence more expensive, parts and equipment.)
The traditional way to fight inflation is to raise interest rates, so that people save more and spend less (thereby cutting demand for goods and services, and with that reduced demand, reduced prices). But raising interest rates, again, depresses the demand for homes and home prices and slows economic output.
And your mutual funds? Well, if you are diversified in a world fund that includes Europe and emerging markets like China and India, you might be OK. But if you are invested wholly in US stocks and the dollar devalues, you become poorer (because you are holding dollar-denominated assets), plus you risk a further decline in these funds as foreigners sell them off to cut their dollar losses. Add to that the higher interest rates necessary to attract investors back to dollars and/or to fight inflation, and it becomes more difficult to start and expand businesses and harder for people to finance purchases, leading to reduced earnings for companies and people -- recession! It is also possible that rising fuel prices would dampen output (more recession) while at the same time leading to inflation. This almost intractable combination is known as stagflation -- intractable because raising interest rates is no longer viable medicine during a recession, since it would only slow the economy further.
What to do about this? The last time the executive and legislative branches were controlled by one party (1992-1994), the Democrats set out to reverse the large deficits run up during the Reagan-Bush presidencies (1980-1992) and eventually produced surpluses. Granted, a strong economy helped, but this strong economy was in part the result of
confidence at home and abroad that the United States was well-managed, and this is a result of the get-serious attitude of the Clinton Administration to control deficits.
Ultimately, economies are built on confidence. If our current Republican-controlled executive and legislative branches continue to "borrow and spend," reasonable investors may lose confidence in the management of the United States and take their investments elsewhere. So far, Republicans have shown no sign of fiscal conservatism, having chosen to lower taxes at the same time as they launched an expensive war on false pretexts. This combination of lower taxes during wartime has never before been tried in the history of this country, and some would argue that only a "complete moron" would try such a thing. (For an interesting prospective on the deficit and why President Bush may actually want it to balloon, see
Opinion) Still, if the tax stimulus grows the economy faster than we accumulate deficits, fine. This doesn't seem to be happening, however, as the comparison with Europe shows: even with our higher growth rate (which is almost entirely due to our higher population growth rate), our deficits are still growing at a faster pace as a percentage of GDP.
I am not predicting doom and gloom, because the Republicans in power own homes, drive SUVs, invest in mutual funds, and ultimately possess self-interest like the rest of us. The question is whether their short-term self-interest in getting reelected has taken precedence over the long-term interest of the nation to avoid the next potentially battering economic downturn. Only time will tell, but the abandonment of one of their core principles -- fiscal conservatism -- cannot be a good sign. That and the world's attitude towards the US dollar are the two things to watch in the coming years.
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Epilogue.
The day after I completed the first draft of this piece, two articles appeared in the New York Time (2/22/05), which I briefly excerpt below.
Stocks Tumble on Spike in Oil Prices. A weaker dollar and a spike in oil prices sent stocks tumbling Tuesday as investors worried that continued currency troubles could lead to higher prices overall and spur inflation. . . . The dollar dropped 1.5 percent against the Japanese yen and also fell against the euro and the British pound. The dollar's weakness combined with a cold snap in the Northeast to drive crude futures past $50 per barrel. . . . The Conference Board reported that consumer confidence fell slightly in February, hurt by January's losses on the stock market, continued high energy prices and slow job growth. . . . The dollar's drop was a negative for oil prices, since most major transactions are conducted in dollars, and foreign oil producers must charge more in order to make up for the falling value of the greenback. The dollar also pushed bond prices slightly lower, with the yield on the 10-year Treasury note rising to 4.28 percent.
Dollar Drops as Bank of Korea Looks to Buy Other Currencies. The dollar fell sharply in the foreign-exchange markets today after the Bank of Korea disclosed plans to step up its purchases of securities denominated in other currencies. . . . The dollar lost more than 1.5 cents in value against the euro, which rose to $1.3229 in afternoon trading in New York from $1.3068 late Monday. It also weakened against the Japanese yen, dropping to 104.21 yen today from 105.54 yen the day before. Australian and Canadian currencies also gained against the dollar, as the Bank of Korea indicated, in a report to the South Korean parliament, that it might keep some of its reserves in those currencies instead of the dollar. The South Korean won posted gains as well. . . . Today, the news led to a quick strengthening of Asian currencies against the dollar, before washing over Europe and propping up the euro, which as the world's second most widely held currency is the logical beneficiary of the dollar's weakness. Over the last few years, many central banks have registered a decrease in their dollar reserves, but this decline owed itself to the revaluation of reserves that reflected a weaker dollar. From 2001 to 2003, the euro's share of the world's currency reserves grew to 19.7 percent from 16.7 percent, according to the International Monetary Fund, although it is still far behind the dollar. The looming prospect that these central banks, especially in Asia's emerging markets, might begin actively seeking out other currencies as storehouses of their wealth has the potential to hammer the dollar even harder . . . . Russia's central bank has said it is rethinking what proportion of dollars and euros it holds, and it ranks as a rising player in the foreign exchange market because of the inflow of money from high oil prices. Some Middle Eastern countries have also indicated they might step up their purchases of euros, at the expense of dollars.
