The dollar down the pan – monetary chaos to follow?

The immediate cause of the sliding dollar is not far to seek. It’s the US deficit with the rest of the world. Last year the USA imported nearly twice as much as it exported. Their current account deficit stands at 6% of national income. If a country is spending more than it’s earning, then it has to pay for the difference.

Every day, it seems, the dollar hits new lows against other currencies. What does this mean for the world economy?

The immediate cause of the sliding dollar is not far to seek. It’s the US deficit with the rest of the world. Last year the USA imported nearly twice as much as it exported. Their current account deficit stands at 6% of national income. If a country is spending more than it’s earning, then it has to pay for the difference.

dollar-toilet-paper.jpg On the foreign exchanges, if goods go one way money goes the other way. Since a currency’s value under floating exchange rates is determined in the global marketplace, a deficit will cause an outflow of currency, leading to a depreciation of the national money. That will lead to exports getting cheaper and imports dearer. In theory this will correct the imbalance over time. It hasn’t been working for the USA.

Now there is one way the authorities can prop up the dollar. That is by jacking up interest rates so holders of dollar-denominated assets will get a better return. But Ben Bernanke, head of the US Central Bank (the Fed), has been busy cutting interest rates to try to avoid a recession in America.

The authorities are now letting the dollar slide. It is inevitable that, as the world economy slows, battles will break out not just between the classes but between capitalist nation states. Competitive devaluation is one way of trying to secure an advantage over other countries. These were called ‘beggar my neighbour’ policies in the 1930s, and they caused world trade to dry up in the Great Depression. It looks like there’s more to come.

The world economic order in 1945 was dominated by the USA. At Bretton Woods the Americans had laid down the basic ground rules of the post-War economic order. The main world reserve currency was to be the dollar, which was regarded ‘as good as gold’. Other capitalist nations had fixed exchange rates against the mighty dollar. Fixed exchange rates meant that a country had to pay for goods from abroad, including any deficit, at a set ratio. If the country ran out of hard cash, they would have to deflate the economy. By making everyone poorer it was believed that the excess demand for imported goods would subside. This is a bit like the ancient medical tradition of applying leeches to the human body to cure a fever. Since bleeding weakens the body, the fever subsides for a while. But of course the treatment deals with symptoms, not the cause of the problem, which in this case was lack of competiveness. The only alternative to deflation under fixed rates was devaluation.

If the country ran out of hard cash, they would have to devalue. If a national currency was obviously showing signs of weakness by running a deficit, it was surrounded by speculative vultures. These people had a one-way bet, as Britain showed in 1967. The speculators could buy other currencies with pounds and wait for the capital gain if devaluation occurred – 14% in one day in this case. If there was no devaluation, then they hadn’t lost anything. So a wall of speculative money could build up, making devaluation inevitable. Mighty America was quite happy to have this medicine dished out to other nations. There was just one country that didn’t have to follow the rules. That was the one that made them up in the first place – the USA.

The US developed a growing deficit over the post-War period. It suffered the fate of empires, falling into decline compared with its crushing preponderance in 1945, and wasting huge sums on an arms race with the USSR. America was able to abuse its privilege of holding the world’s reserve currency by simply printing off dollars to pay its foreign debts. Eventually the edifice created at Bretton Woods cracked as the international balance of forces changed in the course of the post-War economic boom. The USA, no longer able to keep the dollar pinned to its perch, floated the currency in 1971. The era of fixed exchange rates was over. In effect financial markets continually revalued and devalued national currencies

But, if the USA is now allowing the dollar to slide to gain competitive advantage, they’re playing a dangerous game. As Richard Wachman reports (Observer 30th March 2008),

“If the dollar continues to lose ground, and it has fallen by 52% against a trade-weighted basket of currencies since 1985, other countries may not find it worthwhile to invest in dollar denominated assets (which helps to offset the US current account shortfall).”

Now the only thing stopping the dollar from slumping into complete collapse is that other countries (particularly China) are holding on to these dollar assets. But the biggest deficit the USA has is with China. Think about it; China is in effect lending America the money to buy Chinese exports to the USA. How long can that go on for?

If the worth of the dollar is called into question, what would follow? Wachman quotes Jeffrey Frankel of HarvardUniversity. “The US would lose the ‘exorbitant privilege’ of being able to finance its international deficits easily.” It’s a bit like owning the mint. What’s to stop you printing off a few extra quid to have a party? In effect the USA has been continuing to abuse its position as economic top-dog to have a free lunch at the expense of the rest of the world by pumping out dollars to pay its bills.

Wachman consults with economists to discuss the options. Stephen King of HSBC opines

“It is hard to write off the dollar. Sure, the dollar will bump along the bottom for a while. When you have a banking crisis like this, it could take a lot to fix it. It may be two or three years of a long, hard slog. But why would central banks suddenly dump the dollar? That would cut the value of their own substantive dollar assets. Don’t forget, the Chinese have $1.5 trillion of foreign reserves.”

King is saying the Chinese have lost too much money to walk away from the card table.

He concludes.

“Developing nations have opted for the softer option of setting up sovereign wealth funds whose currency portfolios are less than transparent, although analysts believe they are ‘euro-heavy’. These sovereign wealth funds are the most visible manifestation of a shift of economic power from West to East.”

This change is silent, but it is seismic.

Some thinly populated wealthy countries such as oil-exporting Kuwait have had sovereign wealth funds (SWFs) for decades. More recently Norway has been putting its oil money aside for a rainy day – unlike Thatcher, who squandered Britain’s oil wealth from the North Sea on tax cuts for the rich.

But SWFs have suddenly become explosively important. The rising price of commodities has meant countries like Russia have been able to pile up money and re-emerge on the world market and throw their weight around by means of their SWF. Last year their wealth collectively stood at $3,300bn. By 2010 they are likely to be $5,000bn and $10,000 by 2015. These huge sums are like loose ballast in the hold of the world economy. In a storm they could easily punch a hole in the hull. The established imperialist powers always eye the emergence of potential rivals with mistrust. Will the funds be used to settle political scores?

On the other hand no major player in the world economy can afford to ignore these vast funds. Some of the banks trapped in the sub-prime mortgage fiasco have already approached the funds with outstretched begging hands. Whatever the reality, SWFs are part of the process whereby the balance of wealth and power in the world economy is being transformed.

As economist Charles Kindelberger pointed out long ago, world capitalism needs one economic power to take the lead and set the rules. He identified the crisis of the 1930s as so devastating because no one power was able or prepared to run the world trading system. (The world in depression. 1929-39) Though this is not the sole factor, it is an important part of the explanation for why the Great Depression was so severe. In the nineteenth century Britain was the economic hegemon. The twentieth century after 1945 was ‘the American century.’ In between there was international economic chaos. The torch is being passed on once again. Will the gaping hole in international economic regulation have the same consequences as it did in the 1930s?


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