Is the World Losing Faith in the U.S. Dollar?Published: September 02, 2009 in Knowledge@Wharton
As the global economy appears headed toward recovery, concerns are growing that the United States' addiction to massive fiscal stimulus as an economic panacea could eventually lead to an even bigger crisis -- a loss of confidence in the U.S. dollar. Prominent voices are sounding dire warnings, worried that a gradual return to normalcy could undermine the political will needed to control deficit spending and prevent a disastrous long-term decline of the world's primary reserve currency.
Nobel Prize-winning economist Paul A. Samuelson, for example, raised the specter of a "truly global financial panic" if countries funding the U.S. deficit, particularly China, decide their investments in U.S. Treasury securities are no longer safe. Similarly, Warren Buffett warned in The New York Times that side-effects of the current fiscal intervention could be as dangerous as the financial crisis recently averted -- in the form of inflation eroding the dollar's purchasing power.
Preserving the dollar's strength has importance far beyond protecting American tourists from the shock of paying the equivalent of $25 for a hamburger in London or Tokyo. The U.S. dollar exchange rate is a key indicator of the nation's economic health relative to other countries. A declining dollar leaves Americans worse off by driving up the cost of living, making imports of manufactured goods and commodities more expensive, and reducing the value of foreign investments when converted to dollars.
Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term. The U.S. imports far more goods and services than it exports, flooding international markets with dollars and undermining their value. The current account deficit -- the net balance of trade in goods, services, income and transfers -- was $700 billion in 2008. The U.S. trade deficit remains by far the world's largest, although it declined 35% in the first quarter of 2009 as the recession dramatically reduced demand for oil and other imports.
"I see the potential for the dollar to deteriorate quite substantially in the long run," says Wharton finance professor Richard C. Marston, unless Congress and the Obama administration quickly reduce spending as the economy recovers. "If we continue to borrow from foreign countries to sustain our spending, eventually there will come a time when asset holders around the world will begin to wonder whether the U.S. is credit worthy," adds Marston, director of the Weiss Center for International Financial Research.
Reflecting the size of the fiscal stimulus, the federal budget deficit is projected to be $1.6 trillion in 2009 -- the highest level since World War II -- amounting to 11% of gross domestic product (GDP), a dramatic increase from 3% in 2008. To fund its deficit spending, the U.S. depends on the willingness of major trading partners, such as China, Japan and Korea, to purchase and hold Treasury securities paying low interest rates. China has recently voiced serious concern about the potential inflationary impact of the U.S. fiscal stimulus on the value of China's $1.5 trillion in U.S. government securities and other dollar-denominated reserves.
Making matters worse, the U.S. and China have relatively few policy options to immediately address the twin deficits and strengthen the dollar. The prospect of a slow and relatively weak economic recovery in the U.S. makes it unlikely that policy makers would consider raising interest rates or taxes in the near term. As U.S. consumers have cut spending, raising the personal savings rate to 7% of GDP, China's exports have dropped by 20% or more, causing factory closings, unemployment and social unrest that threaten political stability. "China's economy remains export-driven, so it will take whatever steps are necessary to prevent the renminbi from appreciating, including further purchases of U.S. Treasury debt," says Wharton management professor Marshall W. Meyer.
With the prospect of an economic recovery starting by the end of 2009, the biggest threat to the dollar, according to some observers, is the shift from reckless consumer spending during the housing bubble to unprecedented levels of government spending. While aggressive intervention was initially necessary to prevent a global economic collapse, experts warn of federal deficits that could lead to a long-term decline in the dollar. Indeed, the Congressional Budget Office, projecting a cumulative 10-year deficit of $9 trillion by 2019, or 5% of GDP, said long-term deficits driven partly by Medicare and Social Security were "unsustainable" and would reduce the nation's economic growth.
While the deficits and China will impact the long-term direction of the dollar, a different set of factors makes it extremely difficult to predict short-term fluctuations in exchange rates. In the near term, over the next six to 12 months, the dollar will be influenced primarily by the strength of the U.S. economy and the attractiveness of its financial markets, relative to other countries. "To put it mildly, the outlook for the dollar is very confusing," says Wharton management professor Mauro F. Guillen.
"We have certain long-term structural forces that are likely to undermine the dollar," notes Guillen, director of the Joseph H. Lauder Institute of Management and International Studies. "At the same time, the dollar is still the leading reserve currency and serves as a safe haven for investors when there is too much economic uncertainty. So it's important to keep one eye on short-term movements, but keep the other eye on long-term trends affecting the dollar."
The euro, for example, appreciated sharply against the U.S. dollar during the period leading up to the financial bubble, peaking at nearly $1.60 in mid-2008 amid growing concern about U.S. markets. When the financial crisis erupted in late 2008, the euro dropped precipitously to nearly $1.25 in a "flight to quality" as investors sought the relative safety of U.S. government securities. By late August 2009, the euro had appreciated to a more normal level of about $1.40, reflecting increased confidence that the eurozone had begun a sustainable recovery. Similarly, the yen has appreciated about 25% against the dollar, from 124 yen in mid-2007 to 92 yen in early September 2009. Despite weakening early this year, the yen has continued to appreciate during the second and third quarters.
Recent appreciation of the euro and yen versus the dollar partly reflect the regions' faster-than-expected recoveries, with Germany, France and Japan returning to positive GDP growth in the second quarter, compared with a 1% decline in the U.S. A doubling of the U.S. unemployment rate to 9.5%, compared with relative stability in France, Germany and Japan, likely accounted for the slower recovery in the U.S., according to Wharton finance professor Franklin Allen, co-director of Wharton's Financial Institutions Center. "The fear of unemployment in the U.S. is a huge drag on the economy," he adds, as millions of consumers stop spending because they worry about losing their jobs.
Despite the success of its fiscal stimulus and a massive trade surplus with the U.S. ($300 billion in 2008), China prevents the renminbi (RMB) from appreciating by aggressively buying surplus dollars, artificially pegging the exchange rate at about 6.8 RMB to the dollar. China had allowed its currency to gradually appreciate by 17.5% against the dollar between 2005 and 2008, but halted its rise during the economic crisis to prevent further deterioration of its exports.
The policy change "is very counterproductive" because China's massive dollar holdings "are held hostage" to its policy of supporting exports, Marston says. China must continue to invest in U.S. dollar assets and cannot diversify into other currencies without causing a decline in the dollar, which would hurt exports, he states, adding, however, that by subsidizing U.S. consumption in the short run, China increases the trade imbalance and risks a long-term decline in the dollar that will reduce the value of its $1.5 trillion in dollar reserves.
In addition to urging the U.S. to address the risks of inflation, Chinese officials have called for creating an alternative currency reserve system that would offer more stability for its foreign exchange reserves. Still, the dollar is likely to remain the dominant reserve currency for the foreseeable future because the U.S. economy and financial markets are much larger than Europe's, and China's currency isn't freely traded, Marston notes. "China can always relieve its buildup of foreign exchange reserves by allowing the renminbi to start appreciating again." For now, however, China has made a political decision to keep its currency undervalued.
With developed economies returning to normalcy following the elimination of crisis-related currency imbalances, the outlook for exchange rates in coming months will depend largely on how quickly the U.S. economy recovers relative to Europe and Japan. Another important factor is the relative performance of financial markets, "whether hedge funds and other investors choose to invest in dollar or non-dollar assets," Marston says. He sees the potential for further appreciation of the euro and a weakening of the yen, hurting Japanese exports. Overall, though, economic recovery is likely to remain slow in the U.S. and elsewhere, with corporate profits rising much more rapidly than employment -- "the kind of recovery where most Americans will believe we're still in a recession."
The most likely scenario over the next several years is a continuing depreciation of the U.S. dollar as currency markets gradually adjust to reduce the massive trade imbalance, notes Guillen. Despite the global economic slowdown, the U.S. current account deficit is projected to exceed $400 billion in 2009. "The dollar has to depreciate," he says, adding that the trade deficit remains very large even though the dollar has fallen 21% since 2000 (including 5% in 2009 alone).
In addition, "the budget deficit will produce some inflation, and that is likely to undermine the value of the dollar," Guillen notes. Two alternative scenarios would help support the dollar -- global uncertainty leading to a flight-to-safety similar to 2008, or an economic recovery that is strong enough to allow the Fed to rapidly raise interest rates. Since Guillen sees these scenarios as unlikely to occur, "the balance of forces is tending toward a weaker dollar," which he says increases the importance of controlling inflation.
Counting on Cooler Heads
Marston, Guillen and Meyer suggest two steps that can help avoid rising inflation and a loss of confidence in the U.S. dollar.
First, reduce the U.S. budget deficit.
As economic growth slowly builds to a full recovery within two to three years, the bond and currency markets will signal inflation risks requiring the Fed to raise interest rates and Congress to reduce spending. "I'm optimistic that cooler heads will prevail," Marston says, addressing the consequences of the fiscal stimulus before the deficit spirals out of control. "Clearly there will be some deterioration in the dollar" over the next several years. But he expects the Obama administration to avoid a dramatic depreciation by adopting debt-reduction policies similar to the Clinton administration, which balanced the budget for the first time in 30 years in 1998. One likely result is "higher taxes -- very hard to avoid," Guillen says, given the size of the deficit and the unlikelihood that economic growth can generate enough new revenue.
The second step is to support China's gradual shift to a consumer-driven economy.
Whether China allows the renminbi to appreciate, easing the U.S. trade deficit, will depend on it making a long-term transition to a consumer-driven economy, Meyer says. The shift will ultimately be in China's interest by reducing the cost of importing oil, raw materials and food, and promoting political stability. "China faces a serious dilemma. If the U.S. has inflation, China's holdings in dollars go down in value. But if they allow the renminbi to appreciate, it hurts the export economy."
Meyer expects China to eventually make the transition to a consumer economy in five to 10 years, a process that will require retraining workers now in repetitive manufacturing and moving them into service jobs requiring higher skills. There is a growing realization in China, particularly among technocrats, that the export-driven model cannot lead to sustainable growth, he says. By over-investing in fixed assets, such as factories and infrastructure, the current system suppresses household consumption and creates boom-and-bust cycles that undermine stability. The U.S. should provide "every encouragement" for China's transition, including assistance in retraining the workforce, Meyer suggests. "Our interest is served by stability in China."