Dollar meltdown

The New York Times says that the falling dollar tests nerves of Asia's central bankers [subscription required].

There is a gigantic money circulation pattern that has made East Asia prosperous. In this cycle, Americans spend to the hilt, in the process, absorbing an enormous quantity of goods manufactured in Asia. The Asians get a flood of dollars, which presumably should drive up the value of their currencies relative to the dollar, making their goods more expensive, and exerting a brake on this cycle. Instead, the Asians buy US securities, making going into debt cheaper for the Americans, and spurring further consumption. The Asians get rapid economic growth, driven by exports, and the Americans get to live the good life with plenty of goods. There are some unfortunate effects, such as the distress of American workers who lose jobs in manufacturing industries that are no longer competitive, but statistically, the world is overall better off. And who can deny the evidence of the sparkling new skylines of the burgeoning cities of China?

The question is, can this cycle continue indefinitely? If not, can the world wean itself off of this cycle in a gradual fashion, avoiding major economic disruptions, and moving smoothly into a new pattern? The answer to both questions is, seemingly, no. As US deficits and debt climb to record levels as a percentage of the US economy, the limits to the cycle are becoming evident. And it seems that getting off this cycle is not going to be easy.

Japan now has around $820 billion, China around $600 billion, Taiwan $235 billion, South Korea around $193 billion of foreign currency holdings. The bulk of these holdings is in dollars, and are thus vulnerable to a fall in the value of the dollar. Ideally, these countries would gradually diversify their holdings, and also let their currencies rise gradually against the dollar. Gradually domestic spending would take the place of exports in driving their economies. They would also buy more from the Americans. This would enable the Americans to gradually get their economic house in order.

But as the NYT puts it : "The problem for Japan is that it is in so deep that to a large degree it is chained to its American debtor....anything Japan might do to slow its dollar purchases would only create a self-inflicted wound". The economist Richard Koo is quoted "If they could move it all out of dollars in one day, I am sure they would do it in an instant. But if they move 10 percent, and the dollar goes down by 20 percent, they are stuck with 90 percent of the portfolio worth 20 percent less." NYT reiterates: "Japan and China hold too much American debt to be able to diversify discreetly".

What could happen is that the dollar drops rapidly. American interest rates will have to rise to finance the ongoing deficits. American consumption will slow. Asian export-driven growth will vanish. The global economy might shrink.

We are living in interesting times.