February 26, 2004

The US:  Budget Deficits, the Falling Dollar and the Rest of the World.

You may have seen a lot of talk recently about the growing U.S. federal government budget deficit, the continual weakening of the dollar in the foreign exchange market, and the large trade deficit (current account deficit) the U.S. has with the rest of the world.  What to make of all of this and where is it headed?

U.S. Budget Deficits

The Bush Administration recently released its proposed budget for FY2005.  The size of the budget is $2.4Trillion (yes that is a “t”) and has significant increased levels of spending for defense and homeland security.  Discretionary spending not related to defense or homeland security increases by only one half of one percent.  With current federal government budget deficits projected to be $520 billion this fiscal year, many argue the large amount of government borrowing coupled with a lack of private, or household savings, in the U.S. is contributing significantly to our current account deficit.

As Greenspan explained to Congress last week "The current account deficit and the federal budget deficit are related because the large federal dissaving represented by the budget deficit, together with relatively low rates of U.S. private saving, implies a need to attract saving from abroad to finance domestic private investment spending,"

Others including John Taylor, Under Secretary of the Treasury for International Affairs, argue that “These twins aren't related” pointing to the early 1990’s when the budget deficit decreased while the current account deficit grew bigger.

The Falling Dollar

Either way, while the deficits are both growing, the dollar is continuing to fall in the foreign exchange market.  Since the summer of 2001 the Euro has risen by 50% against dollar.  Against Asian currencies, such as China’s Yuan or the Japanese Yen the dollar has fallen much less.  Most of this is due to the central banks of these countries buying up dollars (and thus U.S. government bonds) in an attempt to prop up the dollar and thus help their own country’s export sector.

In one way this is sort of odd.  The U.S. economy is growing nicely compared to Europe so one might think the Euro should be the one falling not the dollar.  But, one has to remember that for about the last 10 years, the U.S. Treasury secretaries, one after another, have followed a “strong dollar” policy.  So maybe the dollar has been overvalued for some time.  Any one in the American manufacturing industry can attest to this.

Some in fact estimate that the dollar is still overvalued!  Looking at the value of the dollar versus a basket of other currencies and weighting it all by trade volumes, the analysis suggests the dollar may fall even further against the Euro not to mention the Asian currencies.

The Rest of the World Responds

Needless to say the Europeans are not trilled with this.  They claim that the Euro has already risen far too much against the dollar and is killing their export sectors.  They would like to see intervention in the FX markets to push the Euro down.

But this is unlikely to happen since the Bush Administration has continuously stated it is not interested in intervening the foreign exchange market.

What is keeping the dollar from falling even further are the actions of those Asian central banks buying up dollars.  An interesting question some have raised is “how long can this go on?”  Maybe the Asians one day will wake up and no longer be willing to buy U.S. bonds.

But this too is unlikely.  Despite the incredibly low yields on U.S. government bonds these central banks keep buying in a mercantilist attempt to grow only through exports.  Plus, these U.S. government securities are default risk-free, unlike some other government bonds.  So chances are a massive sell off of U.S. government debt, while possible, looks improbable. 

So where is all of this headed?  Given that the U.S. government does seem to mind a weaker dollar (it helps U.S. exports and has not resulted in any type of threatening inflation) it seems the U.S. administration will let the markets function, and push others (read Asian governments) to stop interfering with the market.

So what if the status quo remains?

Here is an interesting long term outcome some have put forward:  the relative weak dollar (compared to the real values in the 1990’s) results in an export boom for America.  But unlike the export booms of the past this one is not only in heavy manufactured goods, it is American exports of…Technology.

The American IT revolution is one of the main drivers of the increase in U.S. productivity over the last decade.  At least Alan Greenspan thinks so, as do many growth economists.  The increases in American productivity in turn, have allowed the U.S. economy to grow without inflation.

One question that has perplexed economists over the past few years is why has this technological revolution not spread faster throughout the rest of the world?  Might one of the reasons be the “strong dollar” policies mentioned above?  Maybe what happened is the strong dollar made U.S. IT too expensive for the rest of the world.  Now with a “weaker dollar” maybe U.S. technology becomes less expensive for the rest of the world.

If (and this is a very big if) the rest of the world can import U.S. IT and use it to increase their level of productivity, in same manner it has increased U.S. productivity, then maybe (and this is a big maybe) the rest of the world will see their productivity improve.  With increased productivity comes faster economic growth.  And it is this faster world wide economic growth that the world desperately needs.

If this happens, faster world economic growth will probably mean faster U.S. growth, a reduction in America’s current account deficit, a reduction in the U.S. federal government’s budget deficits (deficits tend to be counter cyclical) and higher savings rates.  Maybe.

All the best,

MB