Fiddling While the Dollar Drops
By David Ignatius
Friday, December 5, 2003; Page A31
Something ominous is happening when the United States reports its biggest surge in productivity in 20 years, as it did Wednesday, and yet the dollar plunges to an all-time low against the euro.
The dollar is sinking these days on good news and bad, and the explanation is pretty simple: Investors around the world are worried that the Bush administration's policies are eroding the value of the U.S. currency. So they're rushing to unload greenbacks, in what could soon become a full-blown financial crisis.
"The dollar crisis is the story," warns James Harmon, an investment banker who headed the Export-Import Bank during the Clinton administration. "A lot of smart money has moved out of the dollar in the last six months," he explains. "Now the latecomers are rushing to sell, and that's adding to the momentum."
The "smart money" includes financial guru Warren Buffett. He disclosed last month in Fortune that since the spring of 2002, he has been making "significant investments" in foreign currencies for the first time in his career. What worries Buffett is that the U.S. trade deficit has "greatly worsened," and is now running at more than 4 percent of GDP. That puts the U.S. economy at the mercy of foreigners, and their willingness to hold surplus dollars.
So long as global investors believed that U.S. authorities were ready to protect the dollar as a reserve currency, they kept adding to their stashes of greenbacks, despite the trade deficit. But that confidence may finally be disappearing.
The dollar's decline during the Bush presidency has been remarkable. It has tumbled about 44 percent from its October 2000 high of about 83 cents to the euro. Over the past year alone, the decline has been more than 15 percent. Investors who trusted in the dollar as a store of value have been clobbered, so it's not surprising that they want to sell, even at current depressed prices. They fear that worse is coming.
"I'm appalled at what's happening to the dollar," says investment banker Felix Rohatyn, a former U.S. ambassador to France. "A basic responsibility of a government is to maintain the value of its currency."
Rohatyn argues that the Federal Reserve should signal that it "will not allow a dollar crisis to happen" by raising the Fed funds rate at which banks can borrow money overnight, from its current low level of 1 percent. Fed Chairman Alan Greenspan insisted recently that there isn't any dollar crisis, which only made some investors more nervous.
If you haven't already gagged on your raisin bran, consider this nightmare scenario -- outlined by an investment banker who for many years headed his firm's currency-trading operations. This veteran trader contends that the markets have entered a cycle in which "overshooting" -- meaning a further sharp fall in the dollar's value -- "is a distinct possibility."
The core problem, he argues, is that China and Japan have been determined to keep their currencies cheap -- China by fixing the yuan at an artificially low level and Japan by intervening in exchange markets to keep the yen from rising. With their undervalued currencies, the Asians can export massively to the United States and accumulate ever-larger surpluses of dollars.
Hence the nightmare scenario: Between them, China and Japan now hold more than $1 trillion in U.S. Treasury bonds, the trader estimates. But with the declining dollar, the Asian giants have suffered severe losses on these portfolios. If they decided to hedge just 20 percent of their dollar exposure, they could drive the dollar down from this week's low of about $1.21 against the euro to $1.35, contends the trader, and other sellers would trigger a further weakening to $1.45 or so. Facing that sort of decline, the Fed would have to boost interest rates to protect the currency. And higher rates, in turn, would drive down the U.S. stock market.
The Bush administration seems comfortable with a cheaper dollar because it's a way of stimulating demand for American products abroad and sustaining the U.S. economic recovery. In other words, it's good politics. But paradoxically, the U.S. recovery will only worsen pressure on the dollar by sucking in more imports.
To prevent a full-blown crisis, the administration must take prompt action. It should pledge to cut the deficit; it should stop playing politics with free trade; and it should signal that it will intervene in currency markets when necessary to protect the dollar's value. Those steps might convince global investors that somebody at the White House is at least minding the store.
© 2003 The Washington Post Company