Dueling on the Dollar

Contrasting articles on the future of the dollar and America’s economic fate hit my desk this week. In the Winter 2005 issue of the Wilson Quarterly carried Robert Aliber’s, “The Dollar’s Day of Reckoning” while the March/April 2005 Foreign Affairs had “The Overstretch Myth” by David Levey and Stuart Brown.
In keeping with his title, Ailber see the current account deficit as unsustainable and eventually leading to a $400 billion correction via the currency market. He argues that a sustainable trade deficit would be no more than $200 billion annually, down from the current level of $600 billion.

The United States today is in a position similar to that of Mexico in 1980, Norway in 1987, and Thailand and Mexico in the early 1990’s. These countries paid the interest on their international indebtedness with some of the funds received from the in-flow of new foreign investments. The United States is now doing the same thing. It is engaging in Ponzi finance, and the game will soon be up.

By the end of 2004, America’s net international indebtedness had increased by some $500 billion for the year, reaching $3 trillion. Its international indebtedness has been increasing at an annual rate of 16 percent, while its GDP has been growing at a six percent rate. In the long run, international indebtedness simply cannot increase more rapidly than GDP. If it did, foreigners would, in theory, eventually end up owning all the assets and securities in the United States. As a practical matter, policy adjustments or the market will ensure that this does not happen.

He sees little likelihood that this adjustment process will be of “soft landing” variety, which would require a steady, rather than a precipitous, decline in foreign demand for US dollar securities of about $100 billion a year for the next few years.
On the other side, Levey and Brown see an American economy that is continuing to lead:

Despite the persistence and pervasiveness of this doomsday prophecy, U.S. hegemony is in reality solidly grounded: it rests on an economy that is continually extending its lead in the innovation and application of new technology, ensuring its continued appeal for foreign central banks and private investors. The dollar’s role as the global monetary standard is not threatened, and the risk to U.S. financial stability posed by large foreign liabilities has been exaggerated. To be sure, the economy will at some point have to adjust to a decline in the dollar and a rise in interest rates. But these trends will at worst slow the growth of U.S. consumers’ standard of living, not undermine the United States’ role as global pacesetter. If anything, the world’s appetite for U.S. assets bolsters U.S. predominance rather than undermines it.

They dismiss any comparison with recent debt crisis in other countries:

There are key differences, however, between those emerging-market cases and the current condition of the global hegemony. The United States’ external liabilities are denominated in its own currency, which remains the global monetary standard, and its economy remains on the frontier of global technological innovation, attracting foreign capital as well as immigrant labor with its rapid growth and the high returns it generates for investors.

Interestingly, both sides see similar consequences of a hard landing.

The decline in the trade deficit must be matched by a comparable increase in annual savings (and therefore slower growth in American’s consumption) and in U.S. production of trade-able goods. While the longer-term results will be positive, the process of achieving them may be extremely painful, including rising rates of inflation, interest, and unemployment, and possibly a severe economic recession.

Levey and Brown:

But even if such a sharp break occurs–which is less likely than a gradual adjustment of exchange rates and interest rates–market-based adjustments will mitigate the consequences. Responding to a relative price decline in U.S. assets and likely Federal Reserve action to raise interest rates, U.S. investors (arguably accompanied by bargain-hunting foreign investors) would repatriate some of their $4 trillion in foreign holdings in order to buy (now undervalued) assets, tempering the price decline for domestic stocks and bonds. A significant repatriation of funds would thus slow the pace of the dollar decline and the rise in rates. The ensuing recession, combined with the cheaper dollar, would eventually combine to improve the trade balance. Although the period of global rebalancing would be painful for U.S. consumers and workers, it would be even harder on the European and Japanese economies, with their propensity for deflation and stagnation. Such a transitory adjustment would be unpleasant, but it would not undermine the economic foundations of U.S. hegemony.

So what has this got to do with intangibles? Well, in today’s financial system, money is the ultimate intangible. No longer backed by precious metals, money is just as valuable as we collectively believe it to be. And that collective belief in the value of the dollar changes (such as this week’s turmoil in the currency markets due to the rumor that South Korea’s central bank was reducing its reverses of dollars and buying other currencies).
More to the point, the key difference between the two sides hinges on American’s intangible asset of what might be called “investment desirability.” Levey and Brown see no reason why foreign investors won’t continue to see the U.S. as the best place to invest; Aliber sees no reason to believe that foreign investors will continue to view us as a special case immune from the laws of economics.
Levey and Brown not only make the case that the U.S. will remain a desirable location for investment, they point out the lack of alternatives. The euro-zone, they argue, is in no economic position to challenge the U.S. In their view, the only thing that can end the U.S. position is the Pogo-scenario (we have met the enemy and they are us):

Only one development could upset this optimistic prognosis: an end to the technological dynamism, openness to trade, and flexibility that have powered the U.S. economy. The biggest threat to U.S. hegemony, accordingly, stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.

I agree that the Pogo-scenario is the most likely cause of an unraveling of the U.S.’s global financial position. The danger is that we undermine our advantages to such an extent that foreigners no longer see the U.S. as a special place to invest – but simply one of many. But I disagree that the triggers will be protectionism and isolationism. Rather, it will be complacency and indifference.
Unfortunately, the signs of complacency and indifference are all around us: the increased difficult of foreigners (scientists, businessmen and yes, investors) to get into the U.S. because of increased concerns over homeland security; the rising budget deficit that the Administration and Congress are unable and unwilling to confront; the picking away at our National Innovation System (as recently documented by the Council on Competitiveness report) while we focus attention of side issues such as tort reform; our blase indifference to the continued trade deficit (including Levey and Brown’s repetition of the argument that the trade deficit is a sign of strength not weakness); and, a foreign policy that continues to treat the Made in America brand as something that will last forever.
Yes, the danger is that we will shoot ourselves in the foot. But it will be by doing nothing in the face of serious challenges. Thus, in the end I come down on Professor Aliber’s side. We face some serious challenges, as the recent GAO report points out. Yet, we seem stuck in ostrich mode. The Levey and Brown argument just strikes me as too much a “what me worry” approach similar to what we have heard in the past. Some times, a little worry is good. In warning us off from “would-be Cassandras,” Messrs. Levey and Brown should remember that Cassandra’s curse was to always be right (but never be believed).
One side note: the Levey and Brown article also refers to the recent work on investment in intangibles argue that “the size and growth rate of the U.S. economy have been seriously underestimated.” It is true that not including intangibles in the national system of accounts has the effect of misrepresenting the size of the economy. (See my January 18 entry on “Underestimating Savings“.) However, I would be very leery of then making the jump, as they do, that this proves that we do not have a national savings problem. The BEA work that I referred to does show an underestimation of savings. But the trend is still downward. And it is that trend, not necessarily the raw number that we need to worry about.


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