The Soft-Underbelly of US Power?

For those that did not see this story two weeks ago (and I am assuming many didn’t, since the US media isn’t all that good at covering stories about international finance—plus, it isn’t the sexiest topic—sorry Matt), central banks in Asia caused a semi-panic by merely suggesting that they would diversify their currency holdings. While the bankers did not say they were going to sell off their dollar reserves they hinted that it was in there interest to diversify their currency holdings. The dollar has fallen drastically against the Euro, and central bankers have considered diversifying there holdings to include more Euros. However, these bankers don’t need to sell off the dollars they already have to cause problems for the US economy—just slow the rate at which they purchase them. Korea merely suggested they would diversify their holdings. An editorial in the Financial Times on February 23^rd sums it up nicely:

“the market overreacted to reports that the Bank of Korea wanted to reduce the share of dollars in its portfolio. What the Koreans actually said was that they want to diversify out of low-yielding US Treasuries into higher yielding securities, which could include riskier US assets as well as non-US government bonds. And they intend to do so by diversifying the flow of reserves, not the $200bn (£105bn) stock. But while Tuesday's sell-off was founded on error, it nonetheless exposed the underlying weakness of the US currency. If the mighty dollar can be rocked by a single paragraph in a report to the Korean parliament something is amiss.”

The events of the 22^nd were quickly dismissed by some as a simple misperception by the markets of the Asian Central Banks’ intentions. Problem solved, right? Wrong. As noted above this episode should act as a warning that something is wrong with the current US economy—a massive vulnerability due to our budget deficit.

For many years the US has been the world’s largest debtor and, unlike most other countries, this has not proven to be a problem. Other states were happy to finance our enormous budget deficits by purchasing Treasury notes—essentially loaning us money—given the high confidence in and strength of the dollar. We are currently relying on the same practice to finance our current deficit, which is an all-time record by the way—currently around $477 billion and set to rise rapidly in the coming years to pay for such things as the prescription drug plan (some estimates by non-partisan analysts say it could reach $1.3 trillion by 2013). With defense spending set to reach an all time high (not that I am complaining) we are even more reliant on foreign governments for finance. Our preponderance of power internationally is dependent upon foreign governments’ willingness to provide us with financing. In fact, in order to cover our current account deficit the US must attract over $2bn of foreign capital per day. Forget about selling off dollars, all these foreign banks need to do is slow the rate at which they purchase dollars and we are in for a rough ride. In the short term this is certainly not in these government’s interests. Asian governments do not want the value of their currency to rise relative to the dollar, essentially making their products more expensive. However, Asia seems to be tiring of their reliance on the dollar and their lack of clout in Western financial circles. As William Pesek has noted, these states realize they are allowing the US to forgo dealing with the problems in its own economy (i.e. the current account and budget deficits). In the long term it is in Asia’s interest to minimize currency outflows and to diversify to a higher yielding currency such as the Euro. The question is will the US be able to clean up its act before this adjustment takes place. Given the likely rise in defense spending and the potential restructuring of social security (the cost of which has also been placed in the trillions) I am, sadly, pessimistic...

Filed as:Politics, Economics