We are used to thinking of the USA as the economic superpower of the world, and the dollar as the strongest currency. Yet the dollar has weakened against the rupee in the last six months, and weakened even more (by 15 per cent) against the Euro in the last year.
Is this a temporary blip or a new trend? “It’s not only a new trend, the dollar is in danger of major collapse,” says Martin Wolf of The Financial Times. At a workshop this week at the National Council of Applied Economic Research, he gave reasons why the US economy, for all its apparent strength, is in danger of stagnation or collapse, and could take the dollar down with it.
US consumers have for years stopped saving and gone on an unprecedented consumption spree, gobbling up imported goods. In consequence the US is running a current account deficit of 5 per cent of GDP, a rate of over-spending no country has sustained for long in history.
At around $550 billion, the US current account deficit is as large as India’s entire GDP! Gargantuan deficits have transformed the US from the world’s biggest creditor country to the biggest debtor. The rest of the world (including India) has become a massive creditor to the US. Investors in Asia and Europe have invested trillions of dollars in US stock market and securities.
But US stock markets have taken such a beating in the last three years that foreign investors have lost a veritable fortune. Dollar bonds look safer, but now they carry very low interest rates. So the dollar is slipping. This is a sign, says Wolf, that the rest of the world is no longer willing to finance American over-consumption. He fears that the dollar might have to depreciate by 30-50 per cent in real terms to end this over-consumption.
That will wreak havoc of another kind. Other countries (including India) hold maybe three-quarters of their foreign exchange reserves in dollars, and may find the real value of these eroding fast. Panicky investors may move out of dollars, pushing down that currency even further. Asian countries found what self-reinforcing havoc could be wreaked on their economies by panic. Could something similar happen to the US? I doubt it. Yes, countries that habitually live beyond their means do come to a sticky end, and their currencies do collapse. Yet I think the US is exempt from this rule, at least in the foreseeable future.
Most countries have to export goods or services to earn foreign exchange. If they run large trade deficits for years, they run short of dollars and suffer a crisis. But the USA can never run short of dollars: it can always print more. In effect, the US can pay for its imports by exporting its own currency. No other country can. “The world, says monetary guru Ronald Mckinnon, is today effectively on a dollar standard.” In the old days the world was on the gold standard, which meant gold exporters (like South Africa) could finance their imports by selling gold.
In the gold standard, countries tied their currencies rigidly to gold, whereas today they float. Yet a huge monetary demand exists for dollars, analogous to the old demand for monetary gold. India cannot finance its imports by exporting rupees. Japan cannot finance its imports by exporting yen. But the US can literally export dollars, because the world has decided that this is the world’s monetary anchor.
Just as an oversupply of gold could lower its price, so too can an oversupply of dollars lower its price (exchange rate). This is at the heart of Wolf’s fears. But unlike other commodities, the dollar is used not for consumption, but for building up foreign exchange reserves. Even if the dollar looks dicey, what other currencies could countries switch to? Japan has been in economic stagnation for a decade, so the yen looks dodgy. Germany too has been stagnating since it merged with East Germany, and is currently in recession.
Neither France nor Britain look remotely like global economic leaders. So, in the foreseeable future, there seems no alternative to the dollar, warts and all. I am reminded of an old story about two villagers who encounter a bear in the forest and began to run for their lives. One villager says, “It’s no use, we can’t run faster than the bear.” The other replies, “I don’t have to run faster than the bear, I just have to run faster than you.”
Something similar, I suspect, will happen in the currency market. If the world economy goes into a tailspin, nemesis will catch up first with the yen and Euro, giving the dollar a break. The dollar looks unattractive, but other currencies look even more so.