CURRENCIES are first and foremost relative prices — in essence, they are measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years. The dollar, relative to the currencies of most of America’s trading partners, is off about 20 percent from its early 2002 peak. Recently it has hit new lows against the euro and a high-flying Canadian currency, likely a harbinger of more weakness to come.
Sadly, none of this is surprising. Because Americans haven’t been saving in sufficient amounts, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit — the broadest gauge of America’s imbalance in relation to the rest of the world — hit a record 6.2 percent of gross domestic product in 2006 before receding slightly this year. America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing.
Economic science is very clear on the implications of such huge imbalances: foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the compensation. The currency of the deficit nation usually bears the brunt of that compensation. As long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping.
The only silver lining so far has been that these adjustments to the currency have been orderly — declines in the broad dollar index averaging a little less than 4 percent per year since early 2002. Now, however, the possibility of a disorderly correction is rising — with potentially grave consequences for the American and global economy.
A key reason is the mounting risk of a recession in America. The bursting of the sub-prime mortgage bubble — strikingly reminiscent of the dot-com excesses of the 1990s — could well be a tipping point. In both cases, financial markets and policy makers were steeped in denial over the risks. But the lessons of post-bubble adjustments are clear. Just ask economically stagnant Japan. And of course, the United States lapsed into its own post-bubble recession in 2000 and ’01.
Sadly, the endgame could be considerably more treacherous for the United States than it was seven years ago. In large part, that’s because the American consumer is now at risk. Consumption expenditures currently account for a record 72 percent of the gross domestic product — a number unmatched in the annals of modern history for any nation.
This buying binge has been increasingly supported by housing and lending bubbles. Yet home prices are now headed lower — probably for years — and the fallout from the subprime crisis has seriously crimped home mortgage refinancing. With weaker employment growth also putting pressure on income, the days of open-ended American consumption are likely to finally come to an end. That will make it hard to avoid a recession.
Fearful of that possibility, foreign investors are becoming increasingly skittish over buying dollar-based assets. The spillover effects of the subprime crisis into other asset markets — especially mortgage-backed securities and asset-backed commercial paper — underscore these concerns. Foreign appetite for United States financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar.
The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour. New legislation is likely that would impose trade sanctions on China unless it makes a major adjustment in its currency. Not only would this be an egregious policy blunder — attempting to fix a multilateral deficit with more than 40 nations by forcing an exchange rate adjustment with one country — but it would also amount to Washington taxing one of America’s major foreign lenders.
That would undoubtedly reduce China’s desire for United States assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure. Moreover, the more the Fed under Ben Bernanke follows the easy-money Alan Greenspan script, the greater the risk to the dollar.
Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive — the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation — driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: no nation has ever devalued its way into prosperity.
So far, the dollar’s weakness has not been a big deal. That may now be about to change. Relative to the rest of the world, the United States looks painfully subprime. So does its currency.