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Danger as the dollar drops
Cat : Euro/ Dollar
Date : 2005-05-04 18:01:31                      Reader : 459
How huge? Last month, the government reported that the United States, deficit in international transactions, mainly trade, reached an unprecedented $666 billion in 2004, a 24 percent increase from the 2003 level and , at 5.7 percent of the economy, about two to three times what most economists consider sustainable.
The administration expects foreigners, mainly Asian central bankers, to keep plugging the trade gap because buying American securities increases their exports. It is also assuming that foreign central banks won't risk the losses in their dollar reserves that would occur if they started shunning dollar- based investments. In brief, the United States is betting that it's too big- in other countries' eyes- to fail.
The dollar's current uptick is just a breather in its overall downward trajectory. It's due largely to higher U.S. interest rates, which lure foreign investors away from euros and into dollar- based investments. But what will happen when the Federal Reserve stops raising rates? Here's a hint: When one Federal Reserve governor suggested recently that rates might peak at a lower level than analysts expected, the dollar promptly slid.
The dollar also drew some of its recent momentum from a government report last month that showed the United States attracted $91.5 billion in net foreign capital in January, easily covering that month's near- record trade deficit, $58.3 billion. That allayed concerns, at least temporarily, about the United States' continued ability to finance its debt on favorable terms. But hedge funds were responsible for much of January's investment, and that clouds the picture.
Hedge funds are often short- term investors that can move out of dollars as quickly as they move in. Given the unreliability of those inflows, and  the enormous borrowing needs of the United States, the country will be dependent on foreign government lenders for a long time.
That’s a precarious position. To close its trade gap, which must be financed by foreigners, and its budget gap, most of which is covered by foreign investors, the United States will need to attract a projected $1 trillion in 2005 alone- an unprecedented sum. At the same time, however, the Bush administration is relying on a cheap dollar to correct America's trade imbalance. So far, the trade deficit has only grown, even as the dollar has fallen. A further decline this year of about 20 percent would probably be needed to begin to have a real impact.
There is gathering evidence that foreign central bankers are seeking to avoid the losses that future dollar investments seem to threaten. Recently, financial markets have been unsettled by comments from Japan, South Korea, India and Russia about diversifying away from dollars.
If the world's central bankers accumulate fewer dollars, the result would be an unrelenting American need to borrow in the face of an ever weaker dollar- a recipe for higher interest rates and higher prices. The economic repercussions could unfold gradually, resulting in a long, slow decline in living standards. Or there could be a quick unraveling, with the hallmarks of an uncontrolled fiscal crisis. Or the pain could fall in between. If foreign reluctance to buy Treasury bonds pushed up long- term interest rates, mortgage rates would follow. If the economy is in a housing bubble, as many analysts believe, higher mortgage rates would pop it, with dire results for homeowners' balance sheets and the overall health of the economy.
The dollar is heading down, no matter what. To mitigate the potential harm, the administration and Congress should deliver on budget discipline- far beyond the lip service that's been offered so far- to limit the amounts the United States needs to attract in loans and pay in interest. The administration should also try to forge cooperation among America's trading partners to manage the dollar's decline. Unfortunately, government leaders aren't poised to do either of those things, though action, not attitude, is what the United States needs.

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