The Dollar Crisis: Causes, Consequences, Cures

Richard Duncan is author of a new book called "The Dollar Crisis: Causes, Consequences, Cures." In it, he argues that the Japanese bubble, the Asian Crisis and the U.S. bubble are related. In Mr. Duncan’s view, problems have been building since the U.S. ditched the Bretton Woods system for what turned out to be a "dollar standard." As Richard will explain, the U.S. has benefited from the dollar standard because the U.S. is allowed to play by different rules. It appears, however, that we've overplayed our hand. But before we find out why Mr. Duncan thinks that a "dollar crisis" is inevitable, let's learn how we got here. 

 
Under the Gold Standard, or the quasi-gold standard Bretton Woods System, such an extraordinary surge in global liquidity would have been impossible.
 
There were automatic adjustment mechanisms inherent in the gold standard that made large, multi-year trade imbalances unsustainable.  For instance, if England had a persistent trade deficit with France, England’s gold would have been shipped to France.  The expanded Monetary Base in France would have allowed an expansion of credit creation that would have resulted in rapid economic growth and, eventually, inflation.
 
The opposite would have occurred in England.  England would have lost gold.  Therefore its Monetary Base would have contracted, necessitating a contraction of credit.  Credit contraction would have caused a recession and, as a result, falling prices.
 
After a few years, with prices in France rising and prices in England falling, the French would have begun to buy more English goods, while the English bought fewer French goods, until equilibrium on the balance of trade was restored.
 
From the beginning of the Nation State up until the early 1970s, that is how international trade worked.  And, it was within that framework that all the classical economic theory of the 18th and 19th Centuries was formulated.
 
Once Bretton Woods broke down, however, the self-adjustment mechanisms inherent in the gold standard ceased to function and the global economy began to operate in a way that would have been entirely inconceivable to Adam Smith or David Ricardo.
 
International Trade no longer had to balance.  Deficits merely had to be financed. Consequently, trade imbalances exploded and the greatest global financial bonanza in history got under way.
 
PRUDENTBEAR.COM:  So it would be impossible for the U.S. to have today's trade deficit under Bretton Woods?
 
RICHARD DUNCAN:  Under the Gold Standard  or the quasi-gold standard Bretton Woods system, the United States could not have run very large current account deficits over many years because those deficits would have depleted its gold reserves, causing credit to contract, driving the economy into recession and pushing prices down until Americans could no longer afford to buy any more foreign-made goods.
 
For example, according to IMF statistics, the market value of the United States’ gold reserves is $83.3 billion.  In 2001, the US trade deficit with China alone was $83 billion.  Therefore, under a gold standard, the entire US gold reserves would have been depleted just to cover one year’s current account deficit with China, wiping out all the base money of the United States.
 
In the post Bretton Woods world, the United States does not have to pay for its deficits with gold.  It can pay with paper money or debt instruments instead—and there are technically no limits as to the amount of such credit instruments that the United States can create.
 
What this means is that the self adjustment mechanism inherent in the Gold Standard that prevented large and persistent trade imbalances ceased to function when Bretton Woods collapsed.  While the surplus nations did experience economic overheating and hyper inflation in asset prices just as they would have under the Gold Standard, the deficit country, the United States, did not deflate because it didn’t have to pay for its deficits out of a limited amount of gold reserves, but instead could finance those deficit by issuing more and more debt instruments…or simply by printing more Dollars.  And that is exactly what it has been doing.
 
PRUDENTBEAR.COM: Okay, but with Bretton Woods now old school, let's talk about how the dollar standard works today. What's to stop us from importing all the goods we want?
 
RICHARD DUNCAN:  In 1988, the US was still a net creditor nation.  Now, its net debt to the rest of the world is roughly $3 trillion Dollars, give or take a couple hundred billion.  That’s approximately 30% of US GDP or 10% of world GDP.
 
Since the United States’ current account deficit is now more than 5% of US GDP per annum, that means the United States’ net debt to the rest of the world will rise to 35% of GDP by the end of 2004, 40% by the end of ’05, 45% by the end of ’06, and so on.  Of course, this rise in net indebtedness as a percentage of GDP will be affected by the rate of GDP growth.  But, it must not be forgotten that the GDP can contract as well as expand; and given the imbalances in the US economy a very painful recession is a more probable scenario than most would like to admit.
 
The problem with the rapid increase in US indebtedness is that the United States must be able to service the interest on that debt.  And, already, here things have begun to turn tricky.
 
Foreign investors now own more than 40% of the US government’s tradable debt, 26% of US corporate bonds, and 13% of US equities.
 
What’s next?  Already US consumers are up to their eyeballs in debt.  Overly indebted US corporations are going bankrupt in droves.  Which sector of the economy will be able to issue (and service) an additional  $500 to $600 billion worth of debt every year—year after year—so long as the present extraordinary trade imbalances persist?
 
If new US Dollar debt instruments of this magnitude are not forthcoming, the surplus nations will have no choice but to convert their Dollar surpluses into their own currencies, causing them to skyrocket and the Dollar to plunge, thereby killing the export goose that laid the golden egg.
 
Fortunately for the near term outlook for the Dollar, the US government has once again begun running massive budget deficits.  And, there’s no doubt, that the US government can service the interest on its own debt.  This year the US budget deficit is expected to exceed $500 billion. However, the Current Account deficit will be $600 billion or more.  So even if the surplus nations buy all of the US government bond issues (which is unlikely for a number of reasons) that’s still not enough to absorb all of their Dollar export earnings.  They would still have to buy more than one hundred billion of other Dollar denominated assets each year.
 
Nonetheless, the re-emergence of very large government bond sales will provide a safe home for a good part of the Dollar export earnings of the surplus nations.  Consequently, it will relieve some of the pressure on the Dollar, since the United States’ trading partners will be able to park at least a significant portion of their Dollar earnings in US Treasuries, instead of being forced to choose between, one, investing them in over-indebted US corporations with questionable accounting standards or, two, throwing their economies into recession by converting their dollar earnings into their own currencies, and thereby causing them to appreciate sharply.
 
Still, this state of affairs cannot continue indefinitely.  The United States cannot continue increasing its net indebtedness to the rest of the world at the rate of 5% of GDP per year.  And, not even the US government can continue running $500 billion Dollar a year budget deficits forever.
 
PRUDENTBEAR.COM:  What's wrong with a huge trade deficit? Haven't we been told that it's a sign that the U.S. offers the best investment opportunities in the world?
 
RICHARD DUNCAN: Some government officials and investment bankers frequently tell the public that the US Current Account deficit is caused by the eagerness of the Rest of the World to invest in the United States.  They reason that the large US Financial Account surpluses resulting from foreign investment in the United States necessitates the large US Current Account deficits, given that the Financial Account and the Current Account must completely offset one another when added together.
 
It is hard to understand how such a ridiculous idea could be taken seriously.  Americans buy more from the rest of the world than the rest of the world buys from the United States because the rest of the world uses very low cost labor to make goods at a much lower cost than American manufacturers can.  This could not be more obvious.  That is why the current account surpluses of Mexico, China, Thailand, and the rest of the Asia Crisis countries rose sharply following the devaluation of their currencies in the 1990s:  their labor costs fell, making their products even more attractively priced to the US consumer.  Is it conceivable that American consumers buy all the foreign made products in their homes and in their closets because other countries what to invest in the United States?  Or is it because those imported products were 50% cheaper than similar goods made in the US?  Wage rates in Chinese factories are $5 per day.  Think about it.
 
In 2002, the United States ran a current account deficit of approximately $500 billion because the rest of the world can manufacture products more cheaply than the US can.  Anyone who tries to persuade the public that the US Current Account deficit is caused by the desire of foreign investors to buy US assets should be laughed at if he actually believes that and ashamed of himself if he doesn’t.  These deficits have resulted in tremendous disequilibrium in the global economy.  The public should not be mislead about their origin.
 
PRUDENTBEAR.COM: You argue that the dollar standard has global implications. Maybe we can understand what you mean by reviewing your explanation of [the] Japanese bubble. What does a lack of constraints under the dollar standard have to do with the Japanese bubble?
 
RICHARD DUNCAN: By the early 1980s, the United States began buying much more from the rest of the world than the rest of the world bought from the United States.  Obviously, this did wonders for the economies of those countries with large surpluses with the US.
   
As a result of those surpluses, the international reserves held by the United States’ trading partners began to pile up.  For example, Japan’s international reserve rose from $3 billion in 1968 to $84 billion in 1989.  Thailand’s rose from $2 billion in 1984 to $38 billion in 1996.
 
In every instance, where international reserves expanded sharply, “Economic Miracles” occurred - for a while.
 
The economies of the surplus nations boomed for two reasons:  The first and more obvious reason is that their exporters made terrific profits and employed large numbers of workers.
 
It is the second reason, however, that was the real spark that set off the economic boom, and it is this reason that is generally not understood.
 
It is as follows:  when exporters brought their dollar earnings home, those dollars entered their domestic banking system and, being exogenous to the system, acted as high powered money.
 
The affect on the economy was just the same as if the central bank of that country had injected high powered money into the banking system: as those export earnings were deposited into commercial banks, they sparked off an explosion of credit creation. That is because when new deposits enter a banking system they are lent and relent multiple times given that commercial banks need only set aside a fraction of the credit extended as reserves.
 
Take Thailand as an example.  Beginning in 1986, loan growth expanded by 25 to 30% a year for the next ten years.  In a closed economy without foreign capital inflows, such rapid loan growth would have been impossible.  The banks would have very quickly run out of deposits to lend, and the economy would have slowed down very much sooner.
 
In the event, however, with such large foreign capital inflows going into the banking system, the deposits never ran out, and the lending spree went on and on.  By 1990 an asset bubble in property had developed.  Every inch of Thailand had gone up in value from 4 to 10 times.  Higher property prices provided more collateral backing for yet more loans.
 
A huge building boom began.  A thousand high rise buildings were added to the skyline.  All the building material industries quadrupled their capacity.  Corporate profits surged and the stock market shot higher.  Every industry had access to cheap credit; and every industry dramatically expanded capacity.  The economy rocketed into double digit annual growth as everything turned to gold in an explosion of investment.
 
And, so it was in all the countries that rapidly built up large foreign exchange reserves: credit expansion surged, investment and economic growth accelerated at an extraordinary pace, and asset price bubbles began to form.
 
Think of Japan in the 1980s; Thailand and the other Asia Crisis Countries in the 1990s; and China today.
 
PRUDENTBEAR.COM:  Why did the Asian miracle end?
 
RICHARD DUNCAN:The Asian miracle ended for the same reason the Japanese miracle of the 1980s ended and for the same reason that the current Chinese miracle will soon end.  Those “miracle” were bubbles and bubbles always pop.
 
I lived in Thailand during the first half of the 1990s, so I can tell you from personal experience that economic bubbles are fun…until they pop.
 
Unfortunately, economic bubbles always do pop.  And when they pop, they leave behind two serious problems.
 
First, they cause systemic banking crises that require governments to go deeply in debt to bailout the depositors of the failed banks. Economic bubbles always end in excess industrial capacity and/or unsustainably high asset prices.  Banks fail because deflating asset prices and falling product prices make it impossible for over-stretched borrowers to repay their loans.
 
During the Bretton Woods era, systemic banking crises were practically unheard of.  Since Bretton Woods broke down, however, they have occurred on a nearly pandemic scale.  There have been at least 40 systemic banking crises around the world between 1980 and today.
 
The second problem economic bubbles leave behind when they pop is excess industrial capacity caused by the extraordinary expansion of credit during the boom years.  The problem with excess capacity is that it causes Deflation.
 
Japan is suffering from Deflation.  Hong Kong and Taiwan have deflation.  Even China, where an economic bubble is still inflating, has been experiencing deflation off and on since 1998.  The rest of the Asia Crisis Countries only avoided deflation by drastically devaluing their currencies and exporting deflation abroad.  Think of the impact that the over expansion of Korea’s semiconductor industry has had on global chip prices.
 
This, therefore, is the point I want to stress:  trade imbalances of the magnitude experienced over the last 25 years cause unsustainable economic bubbles in the surplus countries which subsequently implode, leaving behind wrecked banking systems, heavily indebted governments, excess capacity and deflation.
 
PRUDENTBEAR.COM: Next in line was the United States bubble. Does that mean we can blame foreigners for our bubble trouble?
 
RICHARD DUNCAN: First, I think we should be very careful about assigning “blame” to anyone.  This is a global problem that evolved over decades.  There are simply too many variables to untangle all the cause and effect relationships that produced the extraordinary economic imbalances we are discussing.  Rather than pointing fingers, global policy makers need to work together to find a solution to prevent the occurrence of a world wide economic crisis when the US current account deficit inevitably unwinds.
 
Having said that, it is true that the surplus countries played a role in fueling the New Paradigm Bubble in the United States during the late 1990s.  At that time, the US government temporarily enjoyed a budget surplus (leaving aside the issue of the unfunded Social Security program).
 
That budget surplus was due to all the bubble tax revenues, mostly from capital gains taxes on stocks. During those years, 1998 to 2000, the government stopped selling new Treasury Bonds.
 
Yet that was also the period, following the currency devaluations of the 1990s, that the current account surpluses of the United States’ trading partners expanded very sharply, hitting $400 billion by 2000. Since there were no new US treasury bonds for those countries to buy with their dollar surpluses, they bought agency debt (Fannie Mae and Freddie Mac) and corporate bonds instead. That sparked off the property boom in the US and also facilitated the incredible misallocation of corporate credit at that time. It is no coincidence that the peak of the US economic bubble occurred when there were no new treasury bonds being issued to absorb the growing dollar surpluses of the United States' trading partners. In large part, that bubble happened because the rapidly growing dollar stockpiles of the surplus countries had to be invested in other kinds of US dollar-denominated assets if they were to generate a positive return.
 
PRUDENTBEAR.COM: Now we have a dynamic where we buy goods from Asia and Asia takes those dollars and buys U.S. securities. Sounds good to me, what's the catch? What will make the next five years different from the last five?
 
RICHARD DUNCAN: This state of affairs cannot continue indefinitely.  The United States cannot continue increasing its net indebtedness to the rest of the world at the rate of 5% of GDP per year.  And, not even the US government can continue running $500 billion Dollar a year budget deficits forever.
 
That said, while this situation can’t last indefinitely, it could persist for a number of more years. Not without costs, however.  As we have already seen, the US Current Account deficits are causing an explosion of the global money supply which, in turn, has been responsible for the rise of a series of bubble economies that leave systemic banking crises and deflation behind when they inevitably implode.
 
In other words, the United States’ Current Account deficit, by flooding the world with Dollar liquidity, is creating (in fact, has already created) a global credit bubble of enormous proportions. It is only a matter of time before something will have to give.
 
Either government finances will snap under the strain of bailing out failed banking systems, or deflationary pressure stemming from global excess capacity will undermine corporate profitability to such an extent that unemployment will soar, causing a backlash against free trade, or the rest of the world will eventually lose faith in the ability of the United States to finance its ever growing indebtedness and, in a panic, dump their US Dollar-denominated debt instruments, making it impossible to finance further deficits.
 
One way or the other, this global credit bubble will—like every credit bubble before it—come unwound, the Dollar will lose much of its value, and the US Current Account deficit will correct.
 
Unhappily, the correction of the US Current Account deficit will have extraordinarily damaging impact on the global economy.   The world economy has grown dependent on exporting to the United States.  At 500 billion Dollars, the US Current Account deficit is the equivalent of almost 2% of global GDP—and, that’s before any multiplier effect is taken into consideration.
 
The inability of the United States to indefinitely expand its indebtedness to the rest of the world at the current rate of a Million Dollars a minute means that Asia’s era of export led growth will soon be coming to a close.
 
If policy makers don’t come up with a new source of global aggregate demand to replace that presently created by the US Current Account deficit then the global economy will not be able to avoid a severe and protracted deflationary slump.
 
What’s more, the two principle economic policy tools of the 20th Century, Monetarism and Keynesian fiscal stimulus, are not up to the task at hand.  This crisis has been caused by an explosion of the global money supply.  It cannot be solved by simply printing more money—as many important and powerful people would have you believe.  It might be possible to fight fire with fire, but no one has ever suggested that you can fight liquidity with liquidity.
 
Similarly, governments are already too heavily in debt, or soon will be, to provide the type of fiscal stimulus required to resolve this crisis.  Since most governments have run large budget deficits through goods years and bad over the last several decades, they’re no longer in the position to provide the type of stimulus that Keynes had in mind when he published The General Theory in 1936, which, by the way, was the last time the world experienced this kind of liquidity trap.
 
I tell you without exaggeration that developing a new source of global aggregate demand sufficiently large to replace the stimulus that up until now has been provided by the US Current Account deficit is the greatest challenge facing economic policy makers today.