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October 20, 2009
Exclusive: Trade Deficits Devalued the Dollar
There has been a flood of articles, some quite alarmist, about the coming “collapse” of the dollar as the world’s reserve currency. A widely circulated story in the British Independent newspaper October 6th by Robert Fisk claimed there was an international conspiracy afoot between the Arab Gulf oil states, Russia, China, Iran and France to topple the dollar and replace it with some unspecified “basket” of currencies in which the euro and Japanese yen would play a larger role, and perhaps even the Chinese yuan. Given Fisk’s long record as a left-wing America-basher, the story seemed more in line with what Fisk would like to see happen, than what was likely to happen.
Russia and China have been making noise at international economic meetings all year about the need to move away from “dollar hegemony” in line with their longer campaign for the world to move away from U.S. “political hegemony.” Their desire for a “multipolar” world of finance is in parallel with their desire for a multipolar balance of power in which they would move up as America moves down. But neither the ruble nor the yuan are used widely enough to replace the dollar.
Every U.S. administration, regardless of party, has proclaimed a “strong dollar” policy because the use of the dollar as the leading international currency is a strategic asset. A strong dollar means that in real terms, what America spends overseas, whether to support its military deployments, fund foreign development projects, or buy raw materials and fuel to power its economy, is less than it otherwise would be. It also means that America can print money when it needs to, and the dollars will be accepted because they can be used for more than just trade with the United States. Huge markets have existed for decades offshore for dollar-denominated finance.
The fact that the international price of oil is denominated in dollars has been very important. A strong dollar raises the price of oil to everyone else, who must buy dollars before they can buy oil. A weak dollar, however, leads oil producers to raise their prices to earn the same real return. That makes oil more expensive to Americans, but less expensive in real terms to foreigners who can buy dollars cheaper, giving them a competitive advantage.
America is the largest importer of oil and manufactured goods in the world. Exporters want to both earn dollars and keep the dollar strong. The problem is that when the U.S. runs the huge trade deficits it has run over the last decade, the supply of dollars in the exchange markets exceeds the demand, and the value of the U.S. currency falls. The recent spate of stories about devaluation has come about because the dollar is falling back to its pre-recession level. It actually increased in value during the financial crisis because America was deemed a safe haven for money in a world were economic chaos reigned. Wall Street may not have looked trustworthy, but Treasury securities were still the world’s safest investments. Even a small yield is attractive when everything else is dropping like a stone in the ocean.
The long drop in the dollar’s exchange rate actually occurred during 2001-2008, when the trade-weighted dollar index kept by the Federal Reserve showed a decline from 130 to 96. During this period, the U.S. ran increasingly large trade deficits that set new records for red ink each year. The totaldeficit in goods was $5.4 trillion during the Bush administration. Republican policy makers in both the White House and Congress were completely subverted from their duties by the academic sophistry of ”free trade” and the blandishments of transnational banks and corporations not to think about national finance, only about “globalization.”
Private business does not care about national interests, only their own bottom lines. If they can hike profits by moving factories overseas, offshoring production orders, or loaning money to foreign regimes, they will do so without regard to the impact back home (assuming they even think in terms of having a home). It is the responsibility of the national government to shape the flow of commerce and finance to enhance the country’s prosperity. Besides the issue of a strong dollar and sound finances, the real economy upon which everything else ultimately rests is also put at risk when the Federal government turns a blind eye to international trends.
The American automobile industry, once the vanguard of both the economy and popular culture with its links throughout the industrial sector, suffered trade deficits of $1.1 trillion during the years 2000-2008. The sector had to be bailed out and put through bankruptcy during the downturn to prevent a collapse that would have further dragged down the economy and made recovery even more difficult. Unfortunately, there are similar problems in other sectors. The notion of “cheap imports” is a delusion when the imports are purchased by debt and cause the loss of domestic jobs and income.
The answer to trade deficits in the “free trade” theory is devaluation. As the dollar drops in value, imports become too expensive to buy. This can be very inflationary if the domestic industries that could produce cheaper import substitutes have been driven out of business by the previous flood of imports. Indeed, the tactic of “dumping” used by foreign exporters is aimed at this outcome. Devaluation over the last decade has not reduced the deficit, further undermining the credibility of laissez-faire theory.
In an interesting Wall Street Journal column October 8th, economist David Malpass argued that the negative impact of a weak dollar would be worse than the positive impact on the trade balance from devaluation. “Capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create,” he wrote. Lower investment means slower growth and higher interest rates to finance U.S. debt. He drew comparisons with British policy as it was declining and Chinese policy as it is now rising. But his comparisons left out the topic of trade policy, the 800 pound gorilla no one wants to see standing in the middle of the living room.
The theory of “free trade” was championed by Great Britain in the second half of the 19th century. It was adopted to give British workers cheap food imports (as an alternative to higher wages) while knocking down foreign barriers to British exports. When Manchester and other industrial centers held the lead in the industrial revolution, they could win an open competition. Other countries in Europe who wanted to industrialize called this “the imperialism of free trade” and by the end of the century had adopted protectionist policies to bolster their own growth. Germany and the United States both passed Great Britain in manufacturing capacity by the end of the century. As the British trade balance turned negative, the pound sterling lost its preeminence. The dollar emerged as the dominant currency after World War I when the U.S. became the world’s largest creditor.
Today, Beijing uses an undervalued currency to gain a trade advantage, but what makes China so attractive to investors is market access. The Chinese market is smaller than the American but growing rapidly. The only way to reach it is to build in China. Any surplus production can be exported to the open American market as well. Imports are not welcome by Beijing. And foreign firms are expected to take on a Chinese partner to make sure business is conducted in China’s national interest. Beijing has used asymmetrical market access very effectively to grow, amass capital, and run a surplus.
China now has the world’s largest currency reserves, more than all the other major industrial nations combined. But its yuan cannot replace the dollar because Beijing does not let it freely exchange in the market. The value of the yuan is set by the government to achieve state objectives. It has been allowed to move up some to help China buy more oil and raw materials (as well as oil fields and mines overseas), but not enough to jeopardize the marketing of Chinese exports.
The Japanese yen also cannot replace the dollar because Tokyo does not want its currency to be widely traded for the same reasons China controls its yuan. It wants an undervalued yen to support exports. As long as it runs a trade surplus, it can afford to import oil priced in high dollars like China. Neither country wants the dollar to collapse because they hold so many of them.
At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. At the end of 2008, 45 percent of international debt securities were in dollars. There is some diversification going on in favor of the euro, but the euro zone also has high fiscal deficits and national debts. Only 27 countries in 2008 used the euro as their exchange rate reference, while 66 used the dollar. And the dollar is used more than twice as often in foreign exchange transactions. The dollar’s existence rests on the fact that it is issued by a single large, strong nation-state. The euro’s fate is less certain because it was created by an alliance of sovereign governments still only limping towards unification.
Just because there is not a good alternative to the dollar as the world’s reserve currency does not mean the U.S. can ignore the consequences of its trade imbalance. Devaluation and higher interest rates, lost jobs and a reduced stimulus effort, lower tax revenues and larger debt burdens are not to be dismissed as unimportant to maintaining American prosperity, industrial strength, and financial stability.
The statement of Treasury Secretary Timothy Geithner at the IMF-World Bank annual meeting October 6th contained the following: “We recognize that the world cannot return to a pattern of uneven growth, characterized by an excessive reliance on a single engine of consumption-led growth, while others relied heavily on external demand. First and foremost, the responsibility for tackling these problems rests with sovereign governments, including my own." This provides the rationale for shifting from a negligent market to a national interest basis for trade policy that can strengthen the dollar by reducing the deficit, and bolster jobs and production by requiring capital investment in America to reach the most lucrative market in the world. The need to stabilize the dollar is further justification, along with job creation, for restricting imports to bolster the domestic economy.
While most commentators would prefer to reduce the deficit by increasing exports, that is beyond the reach of national policy in a world where foreign governments will not allow their markets to be overrun by American exports. U.S. exports would have to increase by more than 50 percent to bring the trade account into balance. The U.S. trade deficit in 2006, the last normal year before the global downturn, was $760.3 billion, with imports of $2.2 trillion. There is no combination of foreign export markets that can match the size of the American market that has been lost. The American market is the easiest for U.S.-based producers to reach and satisfy, and should be treated as their rightful preserve by government policy.
FamilySecurityMatters.org Contributing Editor William R. Hawkins is a consultant specializing in international economic and national security issues. He is a former economics professor and Republican Congressional staff member.
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