From: Rakesh Bhandari (rakeshb@STANFORD.EDU)
Date: Tue Sep 16 2003 - 19:26:48 EDT
Couldn't find a weblocation for this, so here it is in full. Yours, Rakesh Dollars & Sense, May-June 2003 p10(2) The decline of the dollar system: a falling dollar could mean the end of U.S. world economic domination. (Making Sense). James K. Galbraith. Full Text: COPYRIGHT 2003 Economic Affairs Bureau Today, the U.S. dollar is the world's reserve currency. Nations around the world invest most of their foreign exchange reserves in dollar assets. The international economic position of the United States depends on this. So long as foreign central banks and international investors are willing to take and hold U.S. assets (including stocks, bonds, and cash) this system works-and shamefully to the interest of Americans. Their demand keeps the value of the dollar high. This means that we have been able to consume comfortably, and in exchange for very little effort, the products of hard labor by poor people. (As the supplier of liquidity to the world system, our situation is akin to that of, say, Australia in the late 19th century when gold fields were discovered, except that, in our case, no actual effort is required to extract the gold.) And meanwhile (thanks to ample cheap imports), we are not obliged to invest unduly in maintaining our own industrial base, which has substantially eroded since the 1970s. We could afford to splurge on new technologies and telecommunications systems whose benefits were, to a very great extent, figments of the imagination. And even when the bubble burst in those sectors, life went on, for most A mericans, substantially undisturbed--at least for now. But for how long can this system endure? There can be no definitive answer; the few economists who have worried about this issue are far from being in agreement. On one side, it is argued that the dominant currency holds a "lock-in advantage"; that is, there are economies (reduced transaction costs and reduced risk) associated with keeping all reserves in one basket. The United States in particular is in a strong position to pressure foreign central banks--notably Japan's--to absorb the dollars that private parties may not wish to hold, at least within limits. Full Size PictureFurthermore, oil is bought and sold in dollars. As a result, oil importers must buy dollars in order to buy oil, and oil exporters accumulate dollars as they sell oil. To some extent this arrangement further strengthens the dollar--though it is not obvious why it requires anyone to hold dollars for very long, once they start falling in value. Against this, the question remains: As the U.S. trade position continues to erode, will foreigners be willing to add to their holdings of dollar assets by enough to allow the United States to return to full employment? The amount to be absorbed at present--the trade deficit at full employment--is in the range of half a trillion dollars per year. This was easily handled when dollar asset prices were rising. But now that these prices are falling, they are not as attractive as they once were. If foreigners are not willing to absorb all the dollars we need to place, and if asset prices do not quickly fall to the point where U.S. stocks appear cheap to investors, dollar dumping is, sooner or later, inevitable. To keep the dollar's fall from getting out of hand, the United States will be strongly tempted to slow the rate at which new U.S. assets reach the world system, by restricting its imports. Having renounced the traditional tools of trade protectionism, it can only do this by raising interest rates, holding down economic growth, and keeping incomes, and therefore imports, well below the full-employment level. In that situation--which may actually already have arrived--the United States joins Brazil and other developing nations as a county effectively constrained by its debts. Indeed, the world prognosis from that point forward becomes grim, since high levels of American demand have been just about the only motor of growth and development (outside, perhaps, of China and India) in recent years. THE UNITED STATES AS A DEBTOR NATION There are economists who advocate dollar devaluation, believing that the richer countries of the world would quickly rally to purchase increasing quantities of made-in-America exports, thus reversing the manufacturing decline of the past 20 years. But this is very unlikely. Exports to the rich regions may not be very price-sensitive. And exports to the developing regions are very sensitive to income and credit conditions, which would get worse. At least in the short and medium term, there is no foolproof adjustment process to be had by these means. Where a high dollar provides U.S. consumers with cheap imports and capital inflows to finance domestic activity, a falling dollar would have opposite effects. A falling dollar would raise the price of imports into the United States, especially from the richer countries. Meanwhile, a declining dollar would hit at the value of developing countries' reserves and their access to credit, and so it would diminish their demand for our exports. (It would help, in some cases, on their debts.) The most likely outcome from dollar devaluation is a general deepening of the world slump, combined with pressure on American banks and markets as global investors seek safer havens in Europe. This specter of financial vulnerability means that for the United States, the combination of falling internal demand, falling asset prices, and a falling dollar represents a threat that can best be described as millennial. (My colleague Randall Wray has called it the "perfect fiscal storm.") The consequences at home would include deepening unemployment. There would be little recovery of privately financed investment, amid a continued unraveling of plans--both corporate and personal--that had been based on the delirious stock market valuations of the late 1990s. The center of the world banking industry would move, presumably to continental Europe. Over time, the United States could lose both its position as the principal beneficiary of the world financial order and its margin of maneuver on the domestic scene. This would be not unlike what happened to the United Kingdom from 1914 to 1950. It is not obvious that senior financial policymakers in the United States have yet grasped this threat, or that there is any serious planning under way to cope with it--apart from a simpleminded view among certain strategic thinkers about the financial advantages of the control of oil. Instead it appears that the responsible officials are confining themselves to a very narrow range of Third-World debt management proposals, whose premises minimize the gravity of the issue and whose purpose is to keep the existing bonds of debt peonage in place as long as possible. The alternative? It would involve rebuilding a multilateral monetary system, demolished for the benefit of the private commercial banks in 1973. The way forward would probably entail new regional systems of financial stabilization and capital control, such as the Asian Monetary Fund proposed by Japan in 1997. Such a course would be unpalatable to current American leadership. But we may find, down the road, that for the sake of our own prosperity, let alone that of the rest of the world, there is no other way. Adapted from "The Brazilian Swindle and The Larger International Monetary Problem," published by the Levy Economics Institute in 2002. The full article is available at <www.levy.org>. James K. Galbraith is professor at the Lyndon B. Johnson School of Public Affairs, University of Texas at Austin, and Senior Scholar of the Levy Economics Institute. His most recent hook is Inequality and Industrial Change: A Global View, co-edited with Maureen Berner.
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