October 16, 2006
"In
the long run, we are all dead."
John M.
Keynes (1883-1946)
Fourth sorrow: "There is
bankruptcy, as the United States pours its economic resources into ever more
grandiose military projects and shortchanges the education, health, and safety
of its citizens."
Chalmers Johnson,
(Sorrows of Empire)
"The moral and
constitutional obligations of our representatives in Washington are to protect
our liberty, not coddle the world, precipitating no-win wars, while bringing
bankruptcy and economic turmoil to our people."
Ron Paul,
U.S. Representative (R - TX)
In 2004, it was revealed that Saudi
Prince Bandar had promised President George W. Bush that Saudi Arabia would
increase oil production and lower oil prices in the months before
the 2004 presidential election—to ensure that the U.S. economy was strong
on election day. This was exposed in Washington journalist Bob Woodward's 2004 book
“Plan of Attack.”. In the weeks leading up to the November 7 (2006)
midterm elections, there is renewed optimism that falling oil and commodities
prices, coupled with a soft housing market, will persuade the Federal Reserve
to lower interest rates next year, and not raise them further. The bond market,
while also sending messages that inflation is not an immediate threat, seems to
forecast slower economic growth in the coming years, and possibly negative
growth for one quarter, while the risk of a recession (two consecutive quarters
with negative growth) is not negligible. The downturn in the housing market
alone would account for a big chunk of this decline in economic growth, as
capital spending slows down and as banks see their mortgage business contract.
Because of the aggressive low interest rate
policy that the Fed pursued after 2001 and because of such financial
innovations as interest-only mortgages, construction and its
related industries are one of the three economic sectors which have created new
employment since 2002, the other two being the health and military sectors.
—However, as a consequence, many over-leveraged homeowners risk being caught in a 'negative
equity' trap in the coming months, when the value of their mortgaged assets is
not sufficient to cover the amounts borrowed. In the past, such squeezing has
resulted in increased foreclosures and banking difficulties.
A downturn in construction would have the negative impact of
removing one of the three pillars of employment growth in the U.S.
—Therefore, we can understand why the Fed is weary of raising interest
rates further. The Fed, in fact, is caught in a dilemma: it cannot raise
interest rates much higher for fear of creating an unmanageable collapse in the
housing market. However, the U.S. is running large current account external deficits ($-791,5 billion in 2005). And, because the American
economy needs to draw a large amount of capital from abroad to finance its
deficit spending, American interest rates must remain competitive.
Indeed, under the Bush administration, a combination of large tax cuts and large increases in military outlays to wage
costly wars abroad have stimulated the economy, in a Keynesian way. However,
this has also pushed the U.S. budget deficit to record current-dollar levels.
In five years, from 2002 to 2006, the cumulative federal budget deficit has
exceeded one and a half trillion (1.5 trillion) dollars. —Since
the rest of the U.S. economy was also in deficit, the only exit was to borrow
abroad the necessary cash. The United States is still borrowing abroad more
than $2 billion a day just to keep this binge of expenses going. From whom?
Mainly from China, Japan and some oil-rich Middle East countries which hold
tons of U.S. dollars.
As a consequence, foreigners own an increasing share of the
federal public debt, that share presently being estimated at $2.1 trillion or
about 42 percent of all the public debt held outside the government (about $5.0
trillion in a total debt of $8.6 trillion). These foreign holdings represent an
amount that is 17 percent of GDP ($12.3 trillion), a share that is increasing
fast toward 20 percent of GDP. Keep in mind that this percentage was less than
1.5 percent in 1970 and less than 1 percent in 1946.
What
does it all mean for the U.S. dollar? As a reserve currency,
there is a built-in demand for the dollar from central banks and from worldwide
operators, such as oil traders, who deal in dollars and who are big buyers of
U.S. securities. These purchases have
the double benefit of shoring up the dollar and of keeping U.S. interest rates
low. That is why the foreign demand for U.S. dollars is not going to collapse
overnight, even if relative American interest rates were to stay flat for a
while. In this sense, it can be said that the U.S dollar has some resilience.
This is one of the "seigniorage" benefits
that accrue to the
United States because its currency is held abroad as a reserve currency.
—In the short run, measured in months, the U.S. dollar should continue
its rebound against other major currencies, as long as oil and commodities
prices are soft and as long as U.S. interest rates remain firm. However, in the
longer run, measured in years, the dire external financial situation of the
United States should begin to weigh more heavily on the dollar.
One
currency against which the U.S. dollar is expected to decline is the Chinese yuan.
Since July 2005, the yuan tracks a basket of
currencies that includes the yen, the euro, the Hong Kong dollar and the South
Korean won. Previously “pegged” to the dollar at the rate of
about eight yuans for one dollar, the yuan has begun a slow appreciation toward
the dollar and stands at a value of 7.9 yuans for one dollar, or at a price of
about 12.6 US¢.
But, at this rate, the yuan is way undervalued and should be
revalued substantially more to reflect China's huge
external trade surpluses. Indeed, China has accumulated foreign exchange reserves in excess of $950 billion, which are invested roughly
three-quarters in U.S. Treasury bills and other dollar-denominated assets, the
rest being invested in other currencies. However, the Chinese government has
expressed a wish to diversify somewhat its pool of foreign exchange reserves toward the
euro or the yen and even increase its strategic stocks of oil.
In 2005, China attempted to spend some of its U.S. dollars
to buy an American oil company, Unocal, for about $18.5 billion.
However, the Chinese offer was unceremoniously rebuffed by the U.S. Congress.
A similar fate was met by Dubai-owned Dubai Ports World in
early 2006, when it bought a British company (Peninsular and Oriental Steam
Navigation Co or P&O for $6.8 billion) that happened to manage six U.S.
ports. The company was forced to disinvest itself from its American interests
by the U.S. Congress.
—The
message sent to foreign lenders was loud and clear: if you accumulate American
dollars, deposit the money in our banks or buy
U.S. government securities (Treasury bills),
but do not attempt to invest them in income-generating real American industrial
assets. How long will that scam last? Nobody knows. But, it most likely won't
last forever.
Rodrigue Tremblay is professor emeritus of
economics at the University of Montreal and can be reached at tremblay.rodrigue@yahoo.com. He is the author of the book
Visit his blog site at: www.thenewamericanempire.com/blog
Author's Website: www.thenewamericanempire.com/
_____________________________________
Posted, October 16, 2006, at 5:30
am
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