America and the Dollar Illusion
By Gabor Steingart
Der Spiegel
Wednesday 25 October 2006
The dollar is still the world's reserve currency, even though it
hasn't deserved this status for a long time. The devaluation of the
dollar can't be stopped - it can only be deferred. The result could
be a world economic crisis.
The following essay has been excerpted from the German best-seller
"World War for Wealth: The Global Grab for Power and Prosperity" by
Spiegel editor Gabor Steingart.
The two things investors crave most are high yields and high
security. Since you can never have both at the same time, the moods
of investors are like an emotional roller coaster. They shift
constantly from fear to greed and back - although major investors,
like corporations and states, clearly prefer security over fancy
returns. Their fear is stronger than their greed. They'll freely
relinquish the really fat profits as long as the stability of their
billions is guaranteed. They're afraid of political unrest, they
loathe overly dramatic changes in currency value and the mere
thought of creeping inflation sends them into a state of panic.
Few countries are able to provide the greatest possible security in
the face of these dangers. They include the United States and
Switzerland. Indeed, this security is why the dollar isn't just used
in trading and investment, but also functions as the world's reserve
currency. Almost every country in the world distrusts its own
currency to the extent that it prefers to invest the money from its
treasury in the United States.
One can almost completely rule out the possibility of political
unrest in the United States. Inflation is combated by the Federal
Reserve Bank. Given the size of the currency's spread and the
quantity of dollars circulating worldwide, speculators have no cause
to get overly anxious about the dollar.
Thus, those who have money prefer to keep it in dollars. The United
States disposes of a virtual monopoly on the commodity called
security. For many investors, purchasing a US government bond is
nothing other than a way of preserving its money. In 2005, only 20
percent of all currency reserves in the world were held in euros,
whereas more than 60 percent were held in dollars. The introduction
of the euro was a considerable success, and one should not downplay
it. Nevertheless, the dollar has remained the world's currency
anchor. As long as this anchor rests firmly on the ocean floor,
stability is guaranteed for the national economies that invest in
the dollar.
But if that anchor should tear itself loose and begin to drift
freely in the ocean of global finance, the chaos that ensues would
result in trouble for more than just exchange rates.
Buying to Avoid Selling
But why are the same traders who used to purchase products now so
mad about dollar bills? Why do they rely on the good called security
- a commodity whose quantity cannot be increased at all? Doesn't
every business student learn that the currency of a country is only
as stable - and hence as valuable - as what the national economy of
that country has to offer and produces? Does no one see that the
tension between the dream and the reality is increasing and that
this tension will snap, leading to suffering for millions?
Of course they see it! Investors can see what is happening. They
wonder about it and shake their heads. It even scares them a little,
sending chills down their spine. But they keep buying dollars as
though possessed. The greater their doubts, the more greedily they
order dollars. Indeed, that's exactly what is so crazy about these
investors and their behavior: The client isn't just a client. He
creates the security he's purchasing by the very act of purchasing
it. If he were to stop buying dollars tomorrow, suspicion about the
currency would spread and insecurity would grow. Then the dream
would end. The dollar would start to falter and all the wealth held
in dollars would lose its value. Of course, that's not something
investors want to see happen.
The only way to fight a weak dollar is to strengthen it. Many people
no longer care whether the US currency still justifies the faith
people seem to have in it. The new game, which amounts to playing
with fire, works exactly the other way around: The dollar deserves
the faith it gets because otherwise it loses that faith. Dollars are
bought so they don't have to be sold. The dollar is strong because
that's the only thing that can prevent it from growing weak. Reality
is ignored because only by ignoring it can the dream come true. Or,
to put it still more clearly: Behaving irrationally has become
rational behavior.
Everyone Knows the Danger
Of course, those playing this game know that, in the long term,
currencies can't be stronger than the national economies from which
they derive. Consumption without production, imports without
exports, growth on credit - these are all things that can't last in
this world. Ken Rogoff, the former chief economist of the
International Monetary Fund (IMF) and a man who thinks as clearly as
he speaks brashly, recently criticized US economic policy even as he
seemed to be praising it: Rogoff said the current boom in the United
States is "the best economic recovery money can buy."
But if things have become that obvious, why aren't investors
recoiling in fear? Why do foreigners, US presidents of all stripes
and even Federal Reserve presidents known for their seriousness
allow themselves to get involved in such a risky game, when the risk
is that of destroying everything? Why aren't those mechanisms of
market regulation functioning that are supposed to represent the
advantage of the capitalist system over planned economies?
The answer is terrifyingly simple: Everyone knows how dangerous the
game is, but continuing to play it strikes them as less dangerous
than quitting. After all, what's to be gained from overreacting?
Investors allowed themselves to get caught in the dollar trap years
ago, and there's no easy way out. If they start taking their dollar
bills and government bonds to the market themselves, they would lose
money - either gradually or all at once. They would like to avoid
both scenarios, at least for a time. A president who does no more
than recognize the situation as an important issue may lose his
position as public discontent looks for a vent. Though the governors
of the Federal Reserve Bank are under the strongest obligation to
tell the truth, they have let the right moment for effective
intervention slip by.
Waiting for the Signal
Alan Greenspan, the legendary former chairman of the US Federal
Reserve, did much to feed the dollar illusion.
Whenever skepticism
increased, he raised the key interest rate. Any rise in the key
interest rate also serves as a sort of risk premium for those who
took their chances by investing in the dollar. When doubts about the
sustainability of US economic growth were heard, Greenspan set out
to dispel them immediately. For a man better known for his mumbling
and preference to keep people in the dark about the financial world,
he spoke with remarkable precision. "Overall, the household sector
seems to be in good shape," he said in October of 2004. If the
global financial market's managers worship Greenspan, then it's at
least partly because he's given their dream a lease on life of
several more years.
His successor has no other option but to do the same thing. He knows
that every piece of advice issued by someone in his position will
have consequences. If he issues a warning about the skewed state of
the economy, the warning itself instantly becomes a self-fulfilling
prophecy. Even if he chooses a subtle formulation, the financial
market will perfectly understand what he's saying. Everyone is
waiting for the sign that the trend has reversed. No one is hoping
for that sign, but no one can afford to miss it either.
At this point, a legitimate objection could be formulated: namely,
that financial markets don't normally obey politicians. So why
aren't the markets correcting themselves in this instance as they
normally do? Who or what is preventing investors from behaving
differently towards the dollar than they behaved towards New Economy
stocks?
They're going to do it. The only question is when. Financial
investors aren't tax collectors or accountants: Their job isn't that
of a meticulous overseer. They love excess, and they regularly cause
markets to overheat. After all, speculation is the business they're
in, and being in that business involves living with the risk of
going too far. Their professional attitude resembles that of race
car drivers whose goal is victory and not avoiding accidents at all
costs. What remains unclear is just how dramatic the crash will be.
Experts have often forecast the effects of a dollar meltdown. If the
downward trend were to begin, interest on credit would rise step by
step in an attempt to curb devaluation. That way, the dollar crisis
would spread from the world of currencies to the real world of
factories, businesses and household accounts within days.
Major and minor private investments yield lower returns when
interest rates climb. People would start to save, the economy would
falter and eventually shrink. The first mass layoffs would arrive
soon afterwards. US citizens would have to once more drastically
reduce their level of consumption, as unemployment and waves of
bankruptcy would shake up the country. Millions of households would
become unable to pay back their bank loans. Then real estate prices
and share values would begin to drop, having been overpriced for
years and used as mortgages for consumer credit. When the real
estate bubble bursts, consumption inevitably dwindles even further.
The hunger for imports would fade, causing problems for exporting
countries as well. It would only be a matter of days before
newspapers would once more feature a term that seemed to have
disappeared decades ago: world economic crisis.
Steroids for the Giant
Last century, the United States already suffered from one deep
economic crisis that gradually spread to the rest of the world. The
Great Depression lasted 10 years and brought mass unemployment and
starvation to the United States. The country's economic power sank
by one-third. The crisis virus wrought havoc all over the West. Six
million people were unemployed in Germany when the economic fever
was at its peak.
Today's investors face a difficult choice, one they're not to be
envied for. They can see the relative weakness of the US economy and
they're registering the tectonic shifts in the world economy. They
know that a great statistical effort is being made to prolong the
American dream. For some time now, government statistics have
announced sensational productivity leaps for the US economy -
productivity leaps that, strange as it may seem, haven't led to any
rise in wages for years. This is in fact genuinely bizarre: Either
capitalists are reaping the fruits of increased productivity all by
themselves - which would be a political scandal even in capitalism's
heartland - or the productivity leaps exist only on paper. There is
much to suggest that the second hypothesis is correct.
Half the world is impressed by the low levels of unemployment in the
United States. The other half knows that these statistics aren't
official, but the result of a voluntary telephone survey. Many of
those who declare themselves employed are assistants and day
workers. Working just one hour a week is enough for one to be
classified as "employed." Given that it's considered antisocial to
declare yourself unemployed, the US statistics may well say more
about American society's dominant norms than about its actual
condition.
The US economy's high growth rates aren't to be completely trusted
either. They are the result of high public and private debt. In no
way do they express an increased output of domestically produced
goods and services that the United States has achieved by its own
strength. They say more about the successful sales ventures of
Asians and Europeans. New loans taken by the US government were
responsible for fully one-third of US economic growth in 2001. In
2003 they were responsible for a quarter. The United States is an
economic giant on steroids - doped so its decline in performance
doesn't become too apparent.
Trust in God, Market Style
For capital market investors, reality isn't reality until the
majority of investors are convinced it is reality and have begun
reacting accordingly. Right now, everyone is watching everyone else
closely. Everyone knows the dream of the stable economic superpower
has ended, but everyone is keeping his eyes shut just a little
longer.
Government bonds and shares don't have any objective value - nothing
you can see, weigh, taste or even eat. Their value is measured by
investors' faith that the purchasing power of $1 million will still
be $1 million 10 years from now, rather than having been reduced by
half. This faith is measured on the markets almost every second -
and the measure used is nothing but the faith of other investors. As
long as the faithful outnumber the skeptics, everything works out
fine for the dollar (and the world economy). The trouble starts the
day the scale begins to tip.
The process is complicated by the fact that investors aren't driven
by blind faith alone. In part, it seems, hard facts also push them
to extend their credit of trust a little longer. US economic growth
- an impressive figure on paper - is an important benchmark. When it
is high, investors feel reassured in their faith in the power of the
US domestic economy to perform well. True, the trade balance deficit
has skyrocketed since it first appeared in the mid-1970s. But the
economy is growing steadily anyway, as the dreamers note with
growing self-confidence. It may not be growing as rapidly as the
Chinese economy, but it is growing twice as fast as the European
economy.
And yet this benchmark is not as reliable as it seems. The faith
investors have in the figure has actually helped create it. After
all, the purchasing price of a government bond feeds almost directly
into state consumption, just as the purchasing price of a share
makes companies more inclined to consume. It also extends the credit
basis of millions of private households - which in turn boosts
consumption. In this way, the expectations of investors - including
the expectation that the United States will continue to grow -
transform into certainties almost all by themselves.
In other words, the capital of trust creates the very growth rates
it needs in order to justify itself. US economic growth, in fact, is
fueled by ever-increasing consumer spending - puzzling given that
American wages are dropping as is industrial output. Still, everyone
knows the answer to this riddle. The rise in consumption isn't based
on an expansion of production, a rise in wages or even an increase
in exports. To a large extent, it's based on the growing debt. But
why do banks keep issuing credit? Because they accept the
ever-increasing prices of stocks and real estate as a kind of
collateral. A closed circuit of miraculous money minting has been
created.
Self-Delusion
The extent of this self-delusion can be read in the balance sheets
of the banks: Almost no one is saving money in the United States
today. The US foreign debt grows by about $1.5 billion every weekday
and has now reached about $3 trillion. Private household debt, both
at home and abroad, has reached $9 trillion - and 40 percent of
these debts has been incurred since 2001. The Americans are enjoying
the present at the cost of selling off ever larger chunks of their
future. Arguably, the imminent economic crisis is the most
thoroughly predicted one in recent history. Rather than refuting the
crisis, the current US economic boom merely heralds it.
Biologists have observed similar phenomena in plants contaminated by
toxins. Before they wither, they produce one last batch of healthy
shoots - to the point that they can hardly be distinguished from
healthy plants. Some speak of a panic bloom.
So who will be the first to destroy the dollar illusion? Aren't all
investors bound together by an invisible link, since every attack on
the key currency would lead to a loss of value for them, perhaps
even destroying a large part of their financial assets? Why should
the central banks of Japan or Beijing throw their dollars onto the
market? What could make US pension funds wilfully destroy their
wealth, held in dollars? What sense would it make to send the United
States into a deep crisis when that crisis could drag all the other
states along?
The underlying motive is the same as the one that once prompted
investors to buy dollars - fear. This time it is fear that someone
else may be faster, fear that the dollar's strength won't last, fear
that every day spent waiting may be one day too long. It's fear that
the herd instinct of global financial markets will set in and
overtake those who can't keep up.
Weaker Than They Say
These days, the dollar is making a lot of people uncomfortable. One
morning many dollar-owners will wake up and look at the facts about
the US economy without their rose-colored glasses - just as private
investors woke up one day and took an unflinching look at the New
Economy, only to see companies whose market value couldn't be
justified by even the most dramatic of profit increases. Some of the
revenue forecasts that had been issued far exceeded the total value
of the market. The Nasdaq presented the spectacle of a stock market
whose added value increased by 1,000 percent in just a few years,
when the nominal growth of the US economy during the same period was
only 25 percent.
Greed triumphed over fear for a few years - but then fear came back.
The value of high-tech shares plummeted by more than 70 percent in
just a few months, and they're still less than half as high as they
were then. Even the Dow Jones, a stock market index based on the
value of the largest US companies, was devalued by some 40 percent.
Much the same fate is in store for the dollar and for dollar loans.
The United States has sold more security than it has to offer. The
expectations traded will turn out to be valueless because they can't
be met. Just as the New Economy was unable to provide investors with
either the growth or the profits that had been predicted for
investors, currency traders will one day have to admit that the
economy backing the currency they sold is weaker than they claimed.
The Crash Can Be Deferred, but Not Stopped
The dependence of foreign central banks on the dollar will defer its
crash, but it won't prevent it. Today's snowdrift will become
tomorrow's avalanche. The masses of snow are already accumulating at
breathtaking speed. The avalanche could happen tomorrow, in a few
months or years from now. Much of what people today think is
immortal will be buried by the global currency crisis - perhaps even
the leadership role of the United States.
Incidentally, the commission that former US President Bill Clinton
created to investigate the negative balance of trade concluded in
clear terms that the government has to do whatever it can to put an
end to the growing disparity between imports and exports. It
demanded that the public give up its optimism and return to realism,
that people start saving again and that the state reduce its imports
in order to prevent too hard a crash landing.
None of that has been done. In fact, what is being done is the
opposite of everything the experts recommended. Debt is growing,
imports are increasing and an optimism now lacking every basis in
reality has become official state policy. Lester Thurow, a member of
Clinton's commission, draws the sober conclusion that no one will
believe the US balance of trade could produce a crisis "until it
happens."