THE ONLY RELIABLE GUIDE TO LIFE IS THAT THE CONVENTIONAL WISDOM IS ALWAYS WRONG:

The President's Conference on the Economy has focused the attention of pundits everywhere on the many issues confronting us today, including the "Twin Deficits" of the Federal Budget and Trade and the sad estate of the Dollar. The New York Times, that fountain of conventional wisdom, wimpered:

The United States, by any measure - trade, the federal budget, personal consumption - is by far the world's biggest debtor. The need to borrow in the face of an already weak dollar portends higher prices and higher interest rates. . . A cheaper dollar would not be as threatening if it was part of a comprehensive strategy to close the trade deficit. For instance, the United States must demonstrate to our trading partners and the currency markets that it intends to reduce the federal budget deficit - thereby lessening its need to borrow from abroad and reducing downward pressure on the dollar. Unless and until it does so, the United States will lack the credibility and the authority to press for changes that need to occur in other countries to balance out global trade. There are alternatives to a single-minded pursuit of a weak dollar fix. What is lacking is the leadership to pursue them.

Later in the same paper I read that France and Germany would not be punished by the EUnics for running persistent budget deficits in excess of 3% of their GDPs. A light went off. If budget deficits are driving the Dollar down, why aren't they having the same effect on the Euro? What about the Yen? Doesn't Japan run deficits also? So I started to research the yen and it just got worse so keep reading.

Budget Deficits: Old Theories v. New Facts (Alan Reynolds, September 22, 2004, Cato.org)

The Economist (11 September 2004) repeats the editors' habitual lecturing about a "reckless" U.S. budget deficit, which amounts to 3.6 percent of GDP. In a related essay, C. Fred Bergsten recycles his ill-fated "hard landing" scares of the 1980s, based on a metaphysical assertion that "larger budget deficits will produce larger American trade deficits . . .. [and] higher interest rates."


The statistical tables at the back of The Economist, by contrast, tell a different tale. Budget deficits in France and Germany are just as large as in the U.S., and the budget gap in Japan is twice as large. Yet all three countries have a current account surplus, not "twin deficits." And the interest rate on 10-year government bonds is only 1.6 percent in Japan.

Australia, by contrast, has maintained budget surpluses since 1998. Yet Australia's current account deficit is larger than that of the United States, as it was in all but one of the past six years. Australia's 10-year interest rate is 5.6 percent -- substantially higher than the U.S. rate of 4.2 percent. Canada, with a budget surplus since 1997, also has a higher interest rate than the U.S, 4.7 percent. These are regular patterns, not anomalies.

From 1994 through 2003, annual budget deficits averaged 5.8 percent of GDP in Japan, compared with 1.6 percent in the U.S. If budget deficits really increased interest rates and current account deficits, then Japan should be experiencing high interest rates and a large current account deficit by now. Countries with budget surpluses, like Australia, should be experiencing much lower interest rates and current account surpluses. The facts obviously don't fit the conventional theory. . .

Perspective: Dollar Disorientation Affects Even Conservative Analysts (Alan Reynolds, December 3, 2004, Cato.org)

. . . The editor of ConservativeBattleline, Don Devine, writes that "entitlements (Social Security and Medicare) must be restrained if confidence is to be restored in the dollar." Does he think the euro is up because Europe is shrinking the welfare state?


Devine was impressed that Japan's prime minister "bluntly told Bush he must deal with American twin deficits in government spending and trade to stabilize the currency." He failed to notice the irony of a Japanese official lecturing an American about budget deficits.

The U.S. budget deficit is 3.7% of GDP, the same as Germany's and France's. Japan's budget deficit exceeded 6% of GDP for the past five years and is now above 7%. If budget deficits explained trade deficits or interest rates, Japan would have the largest trade deficit and highest interest rates.

Conservative columnist Bruce Bartlett likewise found the dollar a handy new rationale for his year-old prediction of "a significant tax increase..."

Bartlett's thesis that a smaller budget deficit would strengthen the dollar by shrinking the current account deficit is false. The U.S. dollar has declined as much against the Australian dollar as against the euro, yet Australia's current account deficit is larger than ours.

Besides, current account deficits are unrelated to budget deficits here or there. The U.S. current account deficit was 0.8% of GDP in 1992, when the budget deficit was 4.7% of GDP. After the budget moved into surplus, the current account ballooned to 2.3% of GDP in 1998, 3.1% in 1999 and 4.2% in 2000. . .

Bartlett notes that foreigners invested $829 billion in the U.S. last year alone, with just $249 billion of that accounted for by foreign central banks. The investment by foreign central banks worries him because it "threatens foreign central banks with large capital losses if U.S. interest rates rise..."

That is their problem, not ours. But it certainly argues against foreign central banks trying to raise U.S. interest rates by selling Treasury securities. That wouldn't work anyway. U.S. budget deficits added hundreds of billions to the world supply of Treasuries since 2001, yet interest rates fell to record lows. . .

Bartlett also worries that future declines in the dollar "could lead to a sharp drop in the stock market and a spike in interest rates..."

The presumption that a lower dollar must sink stocks is incorrect. At the end of last year, The Economist reported its measure of the dollar's value had fallen by 13.8% in 2003, but the U.S. S&P 500 stock index had risen by 26.1% and the Nasdaq by 50.2%. Far from repelling foreign investors, a lower dollar makes U.S. assets a bargain in euro or yen. Foreign bargain-hunting tends to drive U.S. stock and bond prices higher in dollars. . .

Bartlett nonetheless warns: "A further fall of the dollar . . . will raise the prices we pay for foreign goods. This will boost inflation..."

The dollar has been falling for 3 1/2 years, so where's the inflation.

The Bureau of Labor Statistics keeps a price index of imported goods, with the year 2000 equal to 100. In October, the price index for crude oil was at 150.9. But the price index for all other imports was only 99.8 -- up 2.8% from a year earlier, yet lower than 2000. Aside from cars (102.6), the price index for consumer goods was only 98.4. . .

There are doubtless many things worth worrying about, but the old "twin deficits" and "hard landing" theme that a budget deficit leads to trade deficits and hence to some ill-defined catastrophe is not one of them.

The Dangerous Dollar (Robert J. Samuelson, November 17, 2004, Washington Post)

George Bush hasn't much discussed what could be his biggest economic problem. It's not budget deficits or jobs. It's the possible crash of the dollar on foreign exchange markets. . . Worse, there are no obvious ways to prevent it. Nor is it certain how big the threat is. . .

The dollar lubricates the world economy, having replaced gold as the major international currency. . . In 1990 the U.S. current account deficit was $79 billion, or 1.4 percent of gross domestic product. In 2004, it's expected to hit an unprecedented $665 billion, or 5.6 percent of GDP, says economist Nariman Behravesh of Global Insight. The ballooning deficit has two basic causes.

First, the American economy has grown faster than other advanced economies. Since 1990 U.S. economic growth has averaged 3 percent annually, compared with 2 percent for the European Union and 1.7 percent for Japan. America's higher growth sucks in imports; Europe's and Japan's slower growth hurts U.S. exports.

Second, the global demand for dollars props up its exchange rate, making U.S. exports more expensive and U.S. imports cheaper. Indeed, many countries, particularly in Asia, fix their currencies to keep their exports competitive in the U.S. market. Instead of allowing surplus dollars to be sold on foreign exchange markets -- lowering the dollar's value -- government central banks in Japan, China and other Asian countries have purchased more than $1 trillion of U.S. Treasury securities. Private investors have also bought lots of U.S. stocks and bonds. All told, foreigners own about 13 percent of U.S. stocks, 24 percent of corporate bonds and 43 percent of U.S. Treasury securities.

Up to a point, this arrangement benefits everyone. The world gets needed dollars; Americans get more imports, from cars to clothes. But we may now have passed that point. Hazards may outweigh benefits. The world may be receiving more dollars than it wants. A sell-off could spill over into the stock and bond markets and cause a deep global recession. . .

Note, however, that the dollar's vulnerability is a symptom of something else: the addiction of Europe and Asia to exporting to the United States. If their economies grew faster on their own, the massive U.S. payments deficits wouldn't have emerged. The dollar would have quietly drifted down. Foreigners would have invested less in the United States, because they'd have more investment opportunities at home. But Europe suffers from suffocating taxes and regulations. Japan has long favored export-led growth. And about 35 percent of China's exports go to the United States, says economist Nicholas Lardy.

There's a stubborn contradiction. The world may be getting more dollars than it wants, but it likes the source of those dollars: large U.S. trade deficits. China has resisted U.S. pressure to raise the value of its currency; Europeans and Japanese deplore the recent increases in their currencies. Because the dollar's vulnerability reflects other countries' weaknesses, no American president can cure it alone. Contrary to popular wisdom, for example, U.S. budget deficits don't cause U.S. trade deficits. . .


No one knows what will happen. The massive U.S. payments deficits could continue for years, with foreigners investing surplus dollars in American stocks and bonds. Gradual shifts in currency values might reduce the world's addiction to exporting to the United States. Or something might cause a dollar crash tomorrow. In that case, massive intervention by government central banks (buying unwanted dollars) might avert a calamity. Or it might not. We're in uncharted waters. . .

Posted by Robert Schwartz at December 16, 2004 6:14 PM