Viewpoint

Economic impacts of the declining dollar

Recently, the United States approached the precipice of a debt default that raised the question as to why the world’s largest economy was endangering its financial reputation and thus its ability to borrow. In fact, China, which has the world’s second largest economy, has said that the U.S. has threatened its position as the issuer of the world’s main reserve currency and (until now) risk-free debt.

It is unlikely that China would provoke a sudden, international financial calamity, by unloading U.S. Treasury securities and other government debt. Nonetheless, the process of repeated U.S. crises and temporary reprieves will only solidify the Chinese government’s determination to diversify its holdings away from dollar-denominated assets, and will eventually erode the ability of the United States to issue debt at super-low interest rates. Presently, foreign entities i.e. governments, companies and individuals — hold nearly half of the publicly held debt owed by the United States. Of China’s $3.6 trillion in foreign exchange reserves, about 60 percent is estimated to be held in dollar-denominated assets.

As foreign exchange reserves have soared over the last decade, Chinese monetary authorities have attempted to diversify away from dollar-denominated assets with limited success. The motivation for diversification is understandable: Since July 2005, the Chinese currency has been appreciating against the U.S. dollar, so that in terms of local purchasing power, dollar-denominated holdings have been losing value. The overarching problem is that over the longer term, U.S. government finances are not sustainable, in the absence of enhanced tax revenues and restrained spending.

Chinese policy makers are locked into a development model that relies heavily on exports as a source of growth. It’s well recognized that an adjustment to a new, more domestically oriented growth model is required. But that process will take a long time, and progress thus far has been halting. Hence, it’s likely that China will continue to accumulate large dollar oriented foreign exchange reserves.

Most of the earnings received by Chinese exporters are in dollars, so that currency is what the People’s Bank of China accumulates. In principle, the dollars could be exchanged for other convertible currencies, like the euro or the Swiss franc. But any move to sell dollars in large-enough amounts to make a dent in dollar-denominated holdings would likely drive down the value of the dollar in such a way as to diminish the value of the securities held by the central bank.

If the Chinese could diversify their holdings away from dollars without realizing capital losses, the question would be what is the alternative? Government bonds issued by Germany, Switzerland and Britain are safe, but there just aren’t sufficiently large amounts of those securities available for purchase. Does that mean we Americans can rest easy? The answer is no.

Robert J. Barbera, the co-director of the Center for Financial Economics at Johns Hopkins University, has stated that allowing the dollar to lose its status as the world’s premier reserve asset would be the single greatest mistake in American economic history. According to Barbera, it is inevitable that the dollar will gradually lose its position as the world’s monopoly reserve currency. But it has no chance of losing its reserve currency status anytime soon, although it is thought that the job of world reserve currency is too big for the dollar to shoulder alone. Under the current system, every time some country on the other side of the world wants to add one dollar to its reserves, the United States government must issue one additional dollar worth of debt. It can only be a matter of time before the world becomes multi-polar in the use of currencies. As a consequence, could we be on the verge of a much worse recession, far worse than what we experienced during the last fiscal crisis?

It doesn’t take a rocket scientist to speculate that if you continue to print new money to help satisfy quantitative easing requirements, as a basis for economic stimulus and growing government, daily life will get dramatically worse for U.S. citizens. According to noted economists and the Congressional Budget Office, we are in the $16 trillion to 17 trillion debt range and as we continue to borrow much more than we take in we will be in the $21 trillion to $22 trillion debt range or higher in the near to mid-term, which could mean a significant credit downgrade, spiraling inflation, plunging stock market, and possibly widespread economic destruction. Put another way, when we’re spending 30 to 50 percent of our revenue on debt service payments, we will enter into a bond market crisis. The dollar starts to drop along with bond prices. That would set off the spiraling down effect of our economy and the world’s economy as well.

According to the Bureau of Economic Statistics and a recent Almanac copy, the American currency still reigns supreme as it constitutes $3.72 trillion, or 62 percent, of the $6 trillion in allocated foreign exchange holdings by the world's central banks. Keep in mind that the dollar as a percentage of total world money supply has plunged from nearly 90 percent in 1952 to closer to 15 percent now. The Chinese yuan, the yen and the euro each have a greater share of that total.

For a country with a budget deficit in excess of $1 trillion a year, the consequences of losing standing as the world's reserve currency could be dire. If we lose the status as the world's most reliable currency, the United States will lose the right to print money to pay its debt. It will be forced to pay this debt. The number one economic security issue is for the United States to preserve the U.S. dollar as the world’s currency.

For years, China has been accumulating dollars and working hard to keep the value of the dollar up and the value of the yuan down. One of the goals has been to make Chinese products less expensive in the international marketplace. But now China has announced that the time has come for it to stop stockpiling U.S. dollars. And if that does indeed turn out to be the case, than many U.S. analysts are suggesting that China could also soon stop buying any more U.S. debt. 

Furthermore, if the Federal Reserve starts tapering bond purchases and China quits buying our debt, who is going to fill the void? In fact, if there is significantly less demand for government bonds, that will cause interest rates to rise dramatically. And if interest rates rise dramatically from where they are now, that could set off an economic downward spiraling scenario. Remember that China accounts for more global trade than anyone else does, and they also own more of our debt than any other nation does. If China starts dumping our dollars and our debt, much of the rest of the planet would likely follow suit and we would be in for a world of hurt.

The world is changing, and most Americans have absolutely no idea what this is going to mean for them. As demand for the U.S. dollar and U.S. debt goes down, the things that we buy at the store will cost a lot more, our standard of living will go down and it will become a lot more expensive for everyone (including the U.S. government) to borrow money.

Unfortunately, there isn't much that can be done about any of this at this point. When it comes to economics, China has been playing chess while the United States has been playing checkers. 

The false prosperity that most Americans are enjoying today could eventually start disappearing, and most of them will have no idea why it is happening.

William Chevalier lives in Peterborough.

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