US Policymakers Sleepwalking into Currency Crisis
by Steven Lachance
"The exchange rate of the US dollar is bound to decrease eventually and could potentially do so in a way that destabilizes the global economy. Policymakers' persistent failure to respond appropriately to clearly unsustainable trends adds to concerns over future developments." William White, Monetary and Economic Department Head, Bank for International Settlements, January 2006
Crying uncle over Uncle Sam's dollar exports
Unbridled credit expansion and asset inflation in the US are the direct cause of excessive consumption by American households and the near total loss of global competitiveness by domestic industries producing consumer goods. The effect is a current account deficit of $800 billion per year, which the International Monetary Fund estimates will reach almost $1 trillion in 2007. This tidal wave of dollars flowing out of the US is recycled by foreign, mostly East Asian, central banks back into dollar assets in an ad-hoc arrangement known as Breton Woods II. In the brief period in which this arrangement has held, the balance sheets of the Bank of Japan and the People's Bank of China have each been weighed down by nearly $1 trillion in dollar-denominated assets, and officials in Beijing and Tokyo have become visibly skittish about further accumulation.
Viewed from the left side of the Pacific, Breton Woods II is simply a mechanism to transmit inflation from the US to other economies. China has long experienced breakneck economic growth and is waging an increasingly futile struggle to prevent overheating. Soaking up another trillion dollars is clearly a risky proposition for a government keen to maintain economic and social stability. Even Japan, which most international observers assume welcomes inflationary impetus with open arms, is by no means a bottomless reservoir for the rising flood of dollars. While the Bank of Japan cites consumer prices as the benchmark for ending monetary easing, policymakers keep a wary eye on asset prices with memories of the late 80s bubble debacle still fresh in their minds. A nearly 50% run-up in the Topix stock index in the second half of 2005 and, more importantly, double-digit annual price appreciation for prime Tokyo real estate are indications that Japan's dollar absorption threshold may be lower than many think.
Groping for an exit
The East Asian product vendors and financiers face two challenges for a repudiation of the Breton Woods II arrangement: 1) finding alternative buyers for their industrial output; and 2) procurement of raw materials, particularly energy sources, without dollars. Fortunately for China, Korea, and Japan, a potential alternative market is readily available: Asia itself. The region's consumers have the world's highest savings rate and around two-thirds of the total global savings pool. For the most part, their incomes are also expanding robustly. From a lender's perspective, this makes them attractive credit risks, certainly a better option than lending indirectly to consumers without liquidity or income growth. China is rapidly building a consumer credit infrastructure while Japanese banks, solvent again, are sending staff eastward in search of borrowers. Japan and China are already each other's largest trading partners and inter-region trade now dwarfs trade flows across the Pacific.
Procuring raw materials without dollars is a much more difficult and politically sensitive challenge. Unsurprisingly, Japan has taken a very low profile approach, enhancing energy efficiency at home while its corporations expand stakes in raw material suppliers overseas. In contrast, time is a luxury China does not have much of. It is being inundated with dollars just as its economy is on the brink of overheating. As a result, it has become much more aggressive, particularly in trying to secure oil and gas through agreements with such suppliers as Russia and Iran. The benefits for China are obvious; immediately useful materials in exchange for industrial output instead of IOUs with unpredictable future value. For suppliers, yuan acquired either directly or by conversion through euro can be used to procure essentially any type of consumer good, a trade that helps their governments buy the support of mostly impoverished populations.
From MAD to SAD
These efforts amount to East Asia attempting to alter the stakes of repudiating Breton Woods II. At the outset, the region had found itself locked in a relationship of mutual dependence with the US, comparable to the Mutually Assured Destruction (MAD) doctrine of the Cold War. Led by China, the region is trying to shift away from MAD toward a situation that could be described from the US perspective as Singularly Assured Destruction (SAD). With the US unwilling or unable to restrain its imbalances, East Asia is running out of time to alter the stakes. Given the vulnerability of its economy to further inflation, China will almost certainly be the first to have to make the inevitable choice: certain economic collapse as a result of overheating or a chance, however slim, that the result of the end of Breton Woods II will be SAD for the US, rather than MAD for both the US and itself.
A repudiation of the Breton Woods II arrangement by either Beijing or Tokyo would be the seminal event that ends the post-war era. Not only would it terminate the global currency system constructed on the dollar as the international reserve unit, it could also terminate the dollar itself by triggering cascading cross-defaults in the US through a spike in interest rates. Whether this event proves consistent with either the MAD or the SAD doctrine, the outcome for the US would be a sharp contraction in consumption with catastrophic implications for employment and living standards. You would expect a threat of such proportions to elicit an appropriate response by US policymakers.
Zoned out
The present Secretary of the Treasury, John Snow, is fond of quoting Dick Cheney: "deficits don't matter". Alan Greenspan insists the exchange value of the dollar is not the Federal Reserve's responsibility and his successor, Ben S. Bernanke, is best known for threatening to drop dollar bills from helicopters. Recent meetings of the G7 finance ministers and central bank governors discussed aid to Africa, Islamic fundamentalists, and the price of heating oil. It is highly unlikely that the central banks of Japan and China will absorb another trillion dollars worth of inflation from the US, yet the issue is not even on the agenda. At the most basic level, Breton Woods II is a short-term vendor-financing scheme, capable of nothing more than buying time, which US policymakers appear intent on squandering.
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