The shrinkable but (so far) unsinkable dollar

By Peter S. Goodman
The New York Times
Sunday, May 11, 2008

http://www.nytimes.com/2008/05/11/weekinreview/11goodman.html?_r=2&oref=...

If the United States were any other country, these would surely be days of panic and austerity in Washington. With debts spiraling higher, a trade deficit exceeding $700 billion a year, and its currency plunging for years, the government would be forced to cut spending and jack up interest rates in a frantic bid to attract investment.

But the United States is not any other country. For more than half a century, Americans have enjoyed a unique privilege in the global economy: The dollar has been the world's dominant currency, the money used in most transactions and the repository for the national savings of many countries, including China, Japan and Saudi Arabia.

Come what may -- a financial crisis here, a military misadventure there -- Americans could count on money sloshing up thick on their shores. Virtually limitless demand for American government bonds has supported the dollar's value, and kept domestic interest rates down. Americans have been emboldened to spend in blissful disregard of their debts, secure that foreigners would always supply finance. And that devil-may-care spending has in turn fueled economic growth around the world.

This dynamic may be so deeply embedded in the workings of the global economy that it could endure for many years to come: The costs of weaning the United States from its credit habit would ripple far and wide.

But what are the chances that a day of reckoning is coming, when the dollar would be so weak that America would have to play by the rules that apply to every other country? Recent signs do suggest some fraying in the American relationship with its many foreign creditors. The balance of trade has gotten so lopsided and the question marks hovering over the American economy so thick that some foreign governments are beginning to hedge their bets on the dollar.

Russia has been diversifying its hoard of foreign exchange, plunking more into other currencies like the rising euro. In the oil-drenched Middle East, signs suggest a slight shifting to other flavors of money. And markets have been parsing every utterance from Beijing for hints that China may moderate its voracious appetite for dollars.

Meanwhile, China, Russia and Middle Eastern nations have been injecting hundreds of billions of dollars into state-controlled investment pools known as sovereign wealth funds, which have mandates to seek out better gains on their capital than they get from American government bonds.

"These central banks know that holding these low-yielding Treasury bills is just an aid program to the United States, and they want to get out of that business," said Kenneth S. Rogoff, a former chief economist at the International Monetary Fund. "They are very keen to diversify."

Over all, dollars have never been purchased in as large quantities. But, that said, the dollar has been slipping as a percentage of total foreign currency reserves, as nations increasingly sock away other currencies as well, to cushion themselves against crisis. Between 2001 and the end of 2007, the dollar's share of the world's total foreign exchange reserves shrank from about 73 percent to 64 percent, as the euro expanded from about 18 percent to more than 25 percent, according to the International Monetary Fund.

That change does not reflect a selling of dollars, the monetary fund reports. Rather, it captures how the dollar has fallen in value against many currencies, making the total value of dollars a smaller percentage of all money. "It hasn't been an active diversification," said John Lipsky, first deputy managing director at the fund. "Central bankers tend to be the most conservative investors. Whatever they do is going to be done with exceeding caution."

Now, however, people in international financial circles detect a subtle shifting of the ground in confidence about the dollar. A few years ago, the suggestion that another currency could rival the dollar would have been ridiculed. Today, some economists say the dollar could begin surrendering some of the advantages of dominance to the euro over the next decade or two. Longer term, the dollar could find itself eclipsed by China's yuan as the primary money in usage in the world.

For Americans, losing that status could be painful, sending interest rates higher and raising the costs of buying homes and cars. A country that has been operating with essentially unlimited credit might have learn to live within a budget.

But many economists say that chatter about the demise of the dollar is overblown. The United States, despite its problems, has been a remarkably solid place to put money, making it singularly able to attract savings, they point out. The dollar is likely to continue to shed value, and the American economy will grow far slower than India's and China's, they acknowledge. Yet the dollar, they argue, remains one of the few entities that seem to have fundamental staying power in an age of risk and obsolescence. The size of the United States military alone reinforces confidence that America will endure to honor its debts.

Yes, foreigners have been lending alarming amounts of money to Americans, who have spent extravagantly in excess of their means, economists say. One day, balance will be restored in line with the basic laws of economics -- perhaps chaotically, and probably via a substantial fall in the dollar's value.

But "one day" could well get pushed into the future for a long time to come, for the simple reason that codependence governs the global economy: The current flows of capital lubricate world commerce, giving the American consumer the wherewithal to keep buying; those purchases, in turn, generate business and employment from Asia to Latin America.

When Americans head to the mall, backed by foreign largesse, they drive there burning gasoline made from oil pumped abroad, notably the Middle East. They drive home carrying electronics and clothing churned out in Chinese and Japanese factories. Making these goods absorbs commodities -- energy from Australia and Africa; cotton from Texas and California; iron ore from Brazil and India.

Keeping this global assembly line humming has become a primary development strategy for China, as it continues a wrenching transformation from a predominantly agricultural nation into a rapidly industrializing trading power whose factories employ millions of poor farmers streaming toward cities.

China subsidizes many factories, handing out low-interest loans and making land available at below-market prices. Buying up United States Treasury bills helps goose production: China's central bank buys dollars in part to keep the yuan valued lower, making Chinese goods cheaper on world markets. And by helping keep interest rates lower in the United States, China ensures that American consumers can keep buying.

The Chinese "recognize that they have to lend us the money if they want to maintain those markets," said Michael P. Dooley, an economist and a partner in Cabezon Capital, a hedge fund specializing in emerging markets.

China's leaders fear anything that threatens to crimp exports; that would eliminate jobs and send angry peasants back to their villages. So, with more than $1 trillion already invested in dollar-denominated assets, China is loath to do anything that could drive the dollar down precipitously. If it started selling dollars, that could trigger a panic that would send the dollar plummeting.

But some analysts wonder how much longer China can continue to win at this game. Investing money in the United States requires spending that much less on enormous problems at home, like pollution and a shortage of health care. By indirectly making mortgages cheap in the United States, China has helped foster the boom that saturated Miami with glittering condos even as tens of millions of Chinese live in dilapidated concrete block apartments.

On this side of the Pacific, the great real estate bonanza has, of course, ended badly. Some economists point to the real estate bubble as a prime example of the dangers of too much cheap money washing in: Speculators drive prices sky-high, setting markets up for a punishing fall.

"You can have too much of a good thing," said Brad Setser, a former Treasury official now at the Council on Foreign Relations. In this view, if the dollar maintains its status as the global reserve currency, that would be good news for Americans only in the way that another offer for a credit card is good news for a family about to land in bankruptcy: It may stave off foreclosure for another spell, but it makes the ultimate day of reckoning that much worse.

"We continue to run deficits, and a larger share of our income goes to support this," Mr. Setser said. "Our attitude seems to be, 'Lord give us the strength to resist temptation, but not quite yet.'"

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