A Hitchhiker’s Guide to the Galaxy, a classic of science fiction and black comedy, follows the adventures of its earth-born hero as he hitchhikes through space. As the story goes, a government announces that its planet is doomed, and therefore it will move the population to a new planet on three ships. The smallest, the “A” ship, holds the best and brightest the doomed planet has to offer: scientific researchers and key executives. The sizable “C” ship contains those who do the actual work, such as manufacturing. The “B” ship carries those in the middle: “Millions of them. Hairdressers, tired TV producers, insurance salesmen, personnel officers, security guards, public relations executives, management consultants, you name it.”
The “B” ship’s passengers are told by the “A” ship leaders that because they are really important people on the doomed planet, they must go first to find the refuge. In truth, the planet is not doomed, and the “A” and “C” ships are never built. “A” ship types concocted the story to rid their planet of the useless ballast that is the “B” ship.
To understand where the American economy is headed as the dollar drops in value, it is best to think of American workers as populating the three ships:
On the “A” ship are those talented enough to add value regardless of the strength of the dollar—perhaps 1 percent of our working population.
On the “C” ship are those in hard industries that have survived a decade of the strong dollar—about 20 percent of our workers.
On the “B” ship is everyone else.
For the past 10 years, the United States government has worked to keep the dollar strong, following a policy set out by Clinton Treasury Secretary Robert Rubin, former CEO of Goldman Sachs. Under the “strong dollar policy,” “B” ship America luxuriated in cheap imports, an increasingly large fraction of which— roughly one-fifth—was bought on credit.
But foreigners have had their fill of lending us dollars. Since March 2001, the dollar has fallen in value compared to most major currencies, and it promises to drop much further. That means “B” ship America will soon be paying higher prices for the goods it buys, while borrowing fewer dollars.
“C” ship America—the goods-producing sector—is in revolt over the strongdollar policy, as it directly reduces the prices “C” ship America receives for its goods. Indirectly, the strong-dollar policy is based on cleaving American markets wide open for foreign goods without any protection or strategy to develop “C” ship industries.
Treasury Secretary John Snow, previously CEO of the railroad CSX, represents interests that want a weaker dollar, such as the steel and machine-tool makers in Midwestern states critical to Bush’s re-election and the farmers who dominate the rural fifth of America, the Republican heartland.
On May 18, Secretary Snow made headlines with his announcement that the U.S. government would no longer defend the value of the dollar. International traders sitting at their Bloomberg terminals took a collective gasp upon reading his brutal dismissal of the American tradition of maintaining a strong currency. The dollar lunged to multi-year lows.
To prevent an immediate rout, President Bush was trotted out a few days later to restate support for the traditional strong dollar. Yet Snow’s comments confirmed the obvious. As Warren Buffet explained, “What’s happening with the dollar is not a product of the administration’s policy.” Instead, the cause is excessive consumption: “We are a country that is buying more from the rest of the world than we are selling and we’re doing it on a big scale. Any other country in the world that did it on that scale would have had a much greater currency depreciation already.”
There are two ways for a nation to have a strong currency: export goods or export debt. Naturally, both kinds of exports require willing foreign buyers. Few countries have strong currencies.
For the past six years, America’s great export has been not goods but debt. Foreigners sell us oil, cars, computer components, and other goods. In return, we sell them debt and other financial instruments—government bonds, corporate bonds, and securities backed by the mortgages of American homeowners—for which foreigners have seemed to have an almost insatiable appetite. From 1997 to 2002, imports of goods and services increased by a third, while exports of goods and services were flat.
The measure economists use to quantify this export of debt is the “current account”— the broadest measure of foreign trade. The current account is the difference between what we earn overseas (primarily sales of goods, sales of services, and earnings on our overseas investments) minus what foreigners earn here (primarily imports of goods, imports of services, and foreigners’ earnings on their investments in the U.S.). If the current account is negative, we cover the deficit with debt.
Prior to 1983, America’s current account deficit never exceeded 1 percent of GDP. (In fact, it was usually in surplus.) Now, the current account is in massive deficit, and that deficit is rising. We buy more overseas than we sell. In 2003, the current account deficit will be more than half a trillion dollars—over 5 percent of GDP.
Foreigners have been willing to lend massive amounts of money to Americans because of a relatively strong dollar, high financial returns in the U.S., and an almost touching faith in the strength of America. Moreover, foreign governments such as those in Japan and China have also been willing to hold our debt in order to make the dollar stronger so they can build their home industries with exports to America.
Because interest on debt compounds, rising foreign demand for additional U.S. debt cannot go on forever. In fifty years time, each year’s current account deficit will be greater than GDP. At some point, long before then, something must give. That something is the dollar.
The trade crisis of the late 1980s was the only other time America’s current account deficit greatly exceeded 1 percent of GDP. In the six worst years of the ’80s trade crisis, 1984 to 1989, the cumulative current account deficits totaled 16 percent of GDP. At that time, the dollar declined by half.
Yet the current account crisis in 2003 is much worse than it was in 1989, and for the simplest of reasons: while the crisis of the 1980s ended by 1989, today’s has just begun. In the six years from 1998 to 2003, the cumulative current account deficit will total 23 percent of GDP—almost half again as large as the six worst years of the 1980s. The trade deficit in 2003 will come in at least twice as large as that of the 1989 deficit. The 2004 deficit may be larger still.
How low is the dollar likely to go?
As foreign demand for U.S. debt abates, the strength of the dollar will no longer be determined by money flows. It will be determined by trade flows. That means the dollar will decline until those flows come into something approaching historical balance: a current account deficit of about 1 percent of GDP or less.
Returning to historical balance is going to be difficult because of changes in the American overseas investment position. In the 1980s trade crisis, we could count on the enormous investment cushion earned from a century of past trade surpluses. But we have spent all the money our forebears earned, and more, in the past 20 years. Therefore, the current account deficit is going to be larger than the trade deficit in goods and services, and getting back into balance will be all that much harder. Conservatively, this implies the dollar will fall until the trade deficit in goods and services declines from today’s levels of about 4 percent of GDP to under 1 percent of GDP.
How far must the dollar fall to cut the trade deficit by three quarters? Jim O’Neill of Goldman Sachs estimates that to reduce the trade deficit by half through higher exports, a 43 percent decline in the dollar will be required. But even this may not be enough.
The U.S. trade position is worse than during the 1980s to such an extent that steep dollar declines will not necessarily improve the trade deficit. After a big currency decline, a country’s trade deficit will initially worsen because higher prices on foreign imports will more than offset the reduced volume of imports (and increased exports) in the short run.
Structurally, about 80 percent of the current account deficit is caused by deficits within five economic sectors:
In crude oil, we have an $80 billion deficit and no ability to increase production. Even if prices double, consumption is unlikely to decline sufficiently to prevent the crude-oil deficit from rising.
Apparel and related goods constitute a highly labor-intensive sector in which no conceivable dollar decline will make America competitive with Bangladesh and El Salvador. The $100 billion-plus deficits in apparel are unlikely to be materially reduced.
It will take a steep devaluation of the dollar to reduce the deficits in household goods because of the increased production of higher-quality goods in China and growing worldwide production.
A decline in the dollar may eliminate the import of most assembled cars into the U.S. from everywhere but Canada and Mexico, but foreign cars built here require key components from countries like Japan.
Only a severe dollar decline will bring into balance our trade deficit in computers and electronics because of critical Japanese monopolies and low Chinese labor costs.
And forget all the talk about services saving the dollar. We still run a trade surplus in services, but just barely. For example, our entire services surplus is about half our deficit in apparel. And it gets worse. At today’s dollar levels, many U.S. service companies cannot compete with emerging foreign-produced services. Without a severe decline in the dollar, the present surplus in services will soon turn to deficit.
So how low does the dollar have to go to make U.S. furniture manufacturers competitive with China in the American market? How much does the dollar have to fall for U.S. software companies to be competitive with those in India? The answer is more than 43 percent.
What will be the consequences?
First, a dollar decline will end the consumption bubble. We will pay more for foreign goods (about 30 percent of all goods Americans buy are foreign-made). We will no longer be able to pay for about one-third of these with paper IOUs as we do now. We will have to buy fewer or lower-quality goods. To most Americans, this shift from strength to weakness will appear so sudden and painful as to seem the death of the dollar.
Second, a dollar decline will shift wealth and power away from the service sector—the “B” ship. There will be fewer service jobs, and the jobs that survive will pay less. Many in the “B” ship will be lucky to find work in “C” ship industries—for example, foreign-owned auto plants. This may provoke resentment, especially by the millions of American workers who thought they were flying in the “A” ship but turn out to be crashing in the “B” ship.
In contrast, hard industries—“C” ship America—will directly benefit from the dollar decline because they produce goods. And the elites in “A” ship America may do surprisingly well. Although the cost of many manufactured goods will increase, that will be more than offset by the lower costs of almost all services.
Third, a dollar decline will put an end to mass immigration. In the 1990s, America was flooded with cheap labor, mainly in the service sector. Imports bought on credit more than provided immigrants’ fuel, food, clothes, and cars. Since we were not paying for these imports, we could afford the public costs of mass immigration: roads, schools, health care, and welfare. Nothing more exemplified the “B” ship economy than the pro-immigration mantra that there were “jobs that Americans won’t do.” This will become a cruel joke as more and more “B” ship Americans struggle to find work to pay their debts.
Fourth, a decline in the dollar means the American Empire is in trouble, for reasons best explained by Morgan Stanley’s Andrew Xie:
American policy makers should understand that, if the US dollar collapses, the US would likely cease to be the superpower. At the moment, in my view, Americans can enjoy their living standard and still spare so much for defense because of low labor costs in East Asia. If this were no longer the case, Americans would have to do everything themselves and might not be able to put together the war machine that they possess today.
Fifth, a decline in the dollar could upend American politics. Democrats will be tempted to lurch Left, which could result in looting by trial lawyers and government unions. Within the Republican Party, what happens is anyone’s guess. The only thing that can be safely predicted is a purge of the glib globalism that understands little about economics, nothing about national wealth, and less than nothing about comparative labor productivity.
One conceivable replacement for this false faith, and the one I favor, would be some root-canal Republicanism. Take a severe recession. Cut spending. Balance the budget. Secure the borders. Do your homework. Eat your spinach. Take it like a man. Such a program would set credible and serious, if modest, goals for itself. But it is difficult to rally popular passion for such a platform.
Another course, however improbable, would be the adoption of a model based loosely on Japanese and other East Asian success stories. In this respect, the death of the dollar may serve as the economic complement to 9/11, making the hitherto impossible suddenly unstoppable. In broad strokes, a coercive reconstruction of the American economy along East Asian lines is not particularly difficult to understand. Consumers would not be allowed to overspend—they would say good-bye to construction of new subdivisions, large SUVs, and mailboxes full of credit-card offerings. Workers would be forced to save—the carrot of tax cuts on savings and investment would be reinforced by the stick of mandatory savings plans such as those in Singapore. Business would be required to invest in hard industries—the low-interest money now directed toward consumption would be redirected to sectors such as advanced materials, electronic components, and energy. None of these steps would be popular, but collectively they would short-circuit a dollar-driven collapse in U.S. power.
The post-war success of the New Bureaucrats in Japan suggests that such a model requires independent power centers willing and able to force such a model upon the country. This scenario is plausible in the U.S. in the near future because we have such power centers: the uniformed military brass, the politically savvy leadership of what remains of advanced manufacturing, and the brilliant, ruthless, young Republican legal minds now flowing into the security establishment. These are among the few remaining sources of competence and effectiveness within the American political system. They may be the only ones.
The general trends are all moving in the direction of transforming Republicans into the security party—not just the party of national security but also the party of economic security. As Morgan Stanley’s Andrew Xie emphasized, the death of the dollar requires radical action if America is to remain a superpower. Based on the results of the 2002 election—when Republicans ran on military security—economic security might be a political winner. Conceivably, it might be more popular with voters than a return to traditional fiscal conservatism because it would subordinate the pain we face to national purpose. Might it be the secret destiny of the Republican Party to become the political arm of a military-manufacturing-security complex like the one President Eisenhower warned of 40 years ago?
Robertson Morrow is a financial analyst in San Francisco.