Despite low inflation, 2004 may become known as the "year of rising prices." Housing prices reached new record highs, oil prices soared, interest rates rose again, and the price of euros, expressed in dollars, reached never before seen heights. Although a higher euro and lower dollar has the potential to help the U.S. economy in general and the manufacturing sector in particular, it still brings real risks with it. Specifically, the decline of the dollar is unpredictable. Nobody knows how far and how fast it will fall, making financial markets jittery and putting economic growth in jeopardy.
In November 2004, the euro broke through the magic mark of $1.30 per euro. This represented a rise of 52 percent of the euro against the dollar since early 2002, when the dollar had reached its last peak. Comments by Alan Greenspan, Secretary of the Treasury John Snow and others have left the impression that the decline may not be over yet.
Under the right set of circumstances, a lower value of the dollar may be welcome. When the dollar falls, U.S. exports become more competitive, whereas U.S. imports become more expensive. Ideally, this should help to shrink the record U.S. trade deficits. Whatever happens to the trade deficit has direct ramifications for manufacturing. After all, manufactured goods represent between 70 and 80 percent of U.S. trade.
To maximize the benefit of a dollar decline for the economy, the decline has to be gradual and consistent. If the dollar declines too fast, it can lead to rapid inflation and thus to higher interest rates followed by a recession – the hallmarks of a currency crisis.
For now, the U.S. suffers from the opposite problem. The dollar may have fallen too slowly since 2002. Despite the dollar’s decline, the trade deficit rose from 3.6 percent of gross domestic product (GDP) in March 2002 to 5.3 percent of GDP in September 2004. The dollar fell where its decline was easiest, such as against the euro. It fell less where it met resistance, as was the case in Japan, and it stayed stable where it couldn’t move, such as in China. Consequently, the dollar has declined by only 14 percent since February 2002 against an index of all its trading partner currencies, in inflation adjusted terms. Given the high U.S. trade deficit, there is room for further dollar declines.
The dollar’s decline also came in fits and spurts. The decline from February 2002 to November 2004 was interrupted three times as the dollar rose again, even if just for a few months. This made it hard for manufacturers to predict what future demand for their products would look like. New hiring in manufacturing has thus been slow. In 2004, manufacturing firms added 79,000 new jobs after losing 2.6 million jobs from the start of the recession in March 2001 to the end of 2003. As manufacturers slowly expanded their U.S. capacities and exports, the trade deficit continued to widen.
The dollar’s decline has been stalled by the federal government’s appetite for new money from overseas. To finance large budget deficits, the federal government borrowed money from international investors, particularly from central banks in Asia. The result has been a rising demand for dollars from overseas investors which has kept the dollar comparatively high despite the gaping U.S. trade deficit.
Thus, the current situation may have helped to create the seeds of its own undoing, raising the specter of the dollar falling too fast in the future. Eventually, foreign investors will worry about the impact of large U.S. government budget deficits on economic growth. Nobody expects deficits to rise without an effect on interest rates. To compensate for the loss of value that slower growth would mean for their investments in the U.S., they may demand higher interest rates to keep their money here. This does not necessarily translate into a currency crisis, whereby higher interest rates spark a recession and rapidly falling currency values that translate into even higher rates. However, it could mark the beginning of a prolonged period of slower growth and higher interest rates. Either way, higher interest rates and slower growth would be a painful way to fix the trade deficit and to remind the federal government to get its house in order.
The policy responses are clear. The federal government’s irresponsible dependence on international capital flows has helped to bring the U.S. economy closer to the brink of either a financial crisis or a prolonged economic slowdown. To reduce this possibility, federal budget policy needs to be put on a course towards fiscal responsibility.
- Net International Investment Position, Relative to GDP
To finance its trade deficit, the U.S. has had to borrow money overseas for some time. Since 1986, the U.S. has owed more money to foreigners than the other way around. By 2003, the U.S. external debt, net of U.S. owned assets abroad was 22 percent of gross domestic product (GDP).
Sources: Bureau of Economic Analysis, National Income and Product Accounts, Washington, D.c=: www.bea.gov; Bureau of Economic Analysis, International Investment Position, Washington, D.C.: www.bea.gov.
- Average Share of Treasury Issues Purchased By Foreigners
Foreigners have helped to finance the federal government’s debt. For the current business cycle, the average was close to 80 percent of new treasury issues that was financed by foreigners. This is the largest share of new federal debt financed by foreigners since the 1950s.
Source: Board of Governors, Federal Reserve System, Flow of Funds, Washington, D.C.: www.federalreserve.gov
- Share of Foreign Holdings, Major Five Foreign Holders
Among foreign investors in U.S. government debt, a few stand out. Particularly, Japan has been a large investor in U.S. treasury securities – bills and bonds. By June 2004, Japan owned almost $700 billion in U.S. treasuries. This was the equivalent of 16.5 percent of outstanding treasury securities. The top five investors in U.S. treasuries in 2004 – Japan, Mainland China, the UK, Carribean Banking Centers, and Korea – raised their combined share of U.S. treasuries from 15.2 percent in 2001 to 26.9 percent in 2004, at a time when the U.S. deficit saw the return of large budget deficits.
Sources: U.S. Department of the Treasury, Office of International Affairs, Treasury International Capital System, Washington, D.C.: www.treasury.gov.
Christian Weller is a senior economist at the Center for American Progress.