Dollar Losing Its Luster

From the March-April 2004 Trumpet Print Edition

Why do Americans still have it so good? In spite of unprecedented debt burdens caused by budget deficits and trade deficits the likes of which the world has never seen, Americans are still prosperous. Why?

The debt load the U.S. carries would in most countries have caused an economic crisis by now. The U.S., however, continues to finance its deficits with foreign cash flows. Foreign investors now own about 38 percent of U.S. Treasury securities, for example—more than twice the percentage of just a decade ago.

In the short run, foreign investment increases the amount of capital available, so the cost of capital is lowered—enabling corporations to invest in projects that otherwise would not be profitable. This increases productivity, employment and gross domestic product. Consequently, Americans are better off—for now—as the U.S. has been able to muster an ever-greater share of world savings to finance its consumption, economic growth, standard of living and military expansion.

But what about the long run? What if foreign investment into the U.S. starts to dry up?

The U.S. dollar’s value is declining—the main topic at February’s g-7 summit in Florida. While this has immediate benefit for U.S. exports, if it continues to slide some investors may pull out in search of better returns and more security elsewhere. As this happens, the Federal Reserve will be pressured to raise interest rates in order to keep dollar investments—especially government bonds—attractive to foreign investors. Higher interest rates may then lead to sharp declines in equity markets and provoke a crisis for those who carry debt that is manageable only because of low interest rates.

So what? you might ask. The economy has gone through cycles before. And foreigners have historically invested in the U.S. and the dollar because it’s always been the best place to be, right? Maybe, but two things have changed that are gargantuan in scope.

First, the U.S. has accumulated unprecedented levels of debt—personal, corporate and national—which has prompted the International Monetary Fund to warn recently that foreign debt of such record-breaking proportions threatens the financial stability of the entire global economy!

When the U.S. stock market crashed in 1987, America was not even a net debtor nation, let alone to the extent it is now. The next major downturn in the economic cycle could lead to personal and corporate bankruptcies, home foreclosures, unemployment and depression like nothing we’ve seen in recent history—especially if foreign investment dries up.

But why would it?

Because of the second gargantuan change: The U.S. is not the only game in town anymore. An alternative for foreign investors is rapidly developing. Over the past two years, East Asian banks have already partly divested from dollars and invested more heavily in the euro.

In the last year, the euro has surged 22 percent against the dollar. According to Business Week Online (January 26), the assumption of most is that the dollar will continue to fall, especially against the euro.

Middle East energy-producing countries price their oil and gas exports in U.S. dollars but import large quantities of goods from Europe that are priced in euros. Russia also receives most of its revenues in U.S. dollars, but its costs are largely in euros. How long will countries be able to sustain those kinds of losses before they dump the dollar in favor of the euro?

Foreign investment in the U.S. is on shaky ground. America’s foreign “lovers” have bailed out the U.S. time and again, but there’s a new icon on the rise in Europe. As the euro becomes more attractive, America will be left holding the bag of debts it has accumulated. That will lead to catastrophe, because in the long run, simply put, superpowers are not built on debt.