- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

– James Pethokoukis is a Reuters columnist. The views expressed are his own –

The state of the dollar probably hasn’t been a first-tier political issue in the United States since, say, the presidential election of 1896. Back then, it manifested as whether or not America would stay on the gold standard or switch to a bimetallic one. (The William Jennings Bryan “cross of gold” speech and all that.)

The aftershocks of the global financial crisis may now be propelling the dollar back to the political forefront. The greenback’s continuing slide makes it a handy metric that neatly encapsulates America’s current economic troubles and possible long-term decline. House Republicans for instance, have been using the weaker dollar as a weapon in their attacks on the Bernanke-led Federal Reserve.

For more evidence of the dollar’s return to political salience, look no further than the Facebook page of Sarah Palin. The 2008 GOP vice presidential nominee — and possible 2012 presidential candidate — has shown a knack for identifying hot-button political issues, such as the purported “death panels” she claims to have found in Democratic healthcare reform plans. In a recent Facebook posting, Palin expressed deep concern over the dollar’s “continued viability as an international reserve currency” in light of huge U.S. budget deficits.

She might be onto something here, politically and economically. A recent Rasmussen poll, for instance, found that 88 percent of Americans say the dollar should remain the dominant global currency. Now, the average voter may not fully understand the subtleties of international finance nor appreciate exactly how a dominant dollar has benefited the U.S. economy. But they sure think a weaker dollar is a sign of a weaker America.

And that’s the political problem for the Obama administration. Its benign neglect of the dollar is another example of an economic policy — along with TARP and the $787 billion stimulus — that the White House thinks is helping the economy, but many Americans find wrongheaded.

In his New York Times column today, Paul Krugman makes the usual case for a weaker dollar: It helps U.S. exporters and is a necessary part of a global economic rebalancing. And there is some truth in that, particularly the idea that Rising Asia will result in a less-dominant dollar.

But Krugman too easily dismisses the idea that the dollar’s decline could tumble out of control. Former Clinton economic officials such as Robert Rubin and Roger Altman have been making the case that investor concern about budget deficits could lead them to abandon the dollar. As Altman argued in a Financial Times op-ed piece today: “The dismal deficit outlook poses a huge longer-term threat.

Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory. That could lead to a punishing dollar crisis.”

Now many Democrats and liberals, like Krugman, don’t want to hear such talk, fearing a rerun of the Clinton era when the progressive policy agenda was sacrificed on the altar of budgetary rectitude.

But that is a tremendous political and economic gamble, one that may result in taunting Republican cries of “Who lost the dollar?”

Deflation could be the biggest threat to the economy, but gold -- usually an inflation hedge -- is reaching new highs. That's because smart investors aren't playing the inflation trade, they're buying currency crisis insurance.

With the amount being spent by the public sector, with the huge amounts of leverage still in the system, there's a palpable fear that America won't be able to meet its obligations. Relative to GDP, the amount we're borrowing to finance deficits makes us look irresponsible.

When such economies hit a wall, investors make a run on the currency, typically moving their assets to a stronger currency, like the dollar.

But this time the problem is the dollar, along with other leading paper currencies, all of which are threatened by profligate fiscal and monetary policies. So some investors want out of the system entirely. Gold, as my colleague Neil Collins noted earlier, is a way to do that.

The gold market is small enough that a decision by a handful of money managers to increase their asset allocation from, say, zero to 5 percent can move the market. All the gold ever mined would fit aboard an oil tanker; its total weight of 125,000 tons amounts to a few hours' output for the U.S. steel industry.

But economists tell us that inflation isn't a risk now. Are they wrong? No and yes.

The conventional way economists view inflation is to look at things like "output gaps." When the economy falls below a level of output it previously achieved, it is said to have unemployed resources. If you think of inflation as workers demanding and getting higher wages, which leads to higher prices for the goods and services they produce, then inflation isn't a threat.

So economists tell us more borrowing and money printing won't be inflationary as long as people are unemployed.

One problem: Their models ignore the fact that peak output was artificially inflated by a credit binge. Borrowing more to sustain an unsustainable level of spending borders on insanity, yet that's precisely what such economic models tell us we need to do.

There's an extra variable these models don't account for -- the Chinese and all major lenders to the United States. They don't much care if our employment rate is below desirable levels. At a certain point, they may recognize that the United States is acting like a banana republic and choose to stop lending.

When that happens, we might see a "sudden stop" event: Capital inflows to the private and public sector cease as everyone races to get out of dollars.

Eric Sprott, CEO of Sprott Asset Management has $4.5 billion under management, $2 billion of which is invested in physical bullion -- silver and gold -- stored at banks in Canada. Another large chunk is invested in gold stocks.

He views gold as an insurance policy against both inflation and deflation. Central bank quantitative easing policies mean "we're printing paper currency like crazy," so he doubts the long-run value of fiat currencies.

On the flip side, if central banks pull back, you could enter a deflationary spiral, essentially a banking collapse, in which case "your deposits wouldn't be returned to you. Better to have physical gold in your control."

Most economists and investors still labor under the illusion that there's a way out of debt that doesn't involve a drastic reduction in the paper value of wealth. Smart investors aren't so sure and want at least a portion of their assets out of the financial system.

A dollar crisis isn't necessarily coming tomorrow, so there's no guarantee gold's price will keep going higher. Still, gold is a decent insurance policy against economic Armageddon.

– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

Twenty-four years ago, major nations called for depreciation of the dollar to rebalance the global economy. Now, as another effort at rebalancing looms, the dollar will again bear the brunt — though officials will try to ensure its fall is less dramatic this time.

That’s the implication of President Barack Obama’s announcement this week that he will push world leaders for a new global “framework” in which the United States would cut its huge trade and budget deficits.

Agreeing on this framework would be politically difficult, since it would require policy changes by many countries — China, for example, would probably have to rein in its explosive export-led growth.

But as the euro’s climb to a new one-year high versus the dollar this morning shows, markets are starting to think the rebalancing process may start as soon as this week’s Pittsburgh summit of leaders from the Group of 20 nations.

The Plaza Accord of 1985 called for “orderly appreciation of the main non-dollar currencies against the dollar”; it was followed by central banks’ coordinated intervention to ensure that happened.

This time, with the world shakily emerging from a financial crisis, policymakers are likely to try to manage the dollar’s drop in a more low-key fashion.

They are unlikely to issue an explicit call for the dollar to fall. In fact, the U.S. Treasury may continue proclaiming its “strong dollar policy” in an attempt to keep the markets calm.

No one in the G20 wants to risk a freefall of the dollar that could disrupt global trade as it recovers from recession. And in contrast to the 1980s, developing nations such as China are now challenging the dollar’s long-term role as the world’s top reserve currency.

The dollar’s premier status helps the United States to obtain foreign capital and in order to keep that access, Washington is likely to encourage central banks around the world to continue holding dollars. This would require slow depreciation of the currency rather than a panicky slide.

So unless policymakers completely lose control of the forex markets — which cannot entirely be ruled out — the dollar’s slide is likely to be slower and smaller than it was after the Plaza Accord, when the currency sank about 50 percent versus the yen between Sept. 22, 1985 and the end of 1987.

The overall direction of the dollar does not look in doubt, however. Top presidential adviser Lawrence Summers has said he wants a U.S. economy that is “more export-oriented and less consumption-oriented”.

A lower dollar is a logical tool to achieve that goal, and letting the currency weaken would probably be faster and easier than most other big policy steps to reshape the U.S. economy, such as tax changes and health reform.

The International Monetary Fund, which is advising G20 nations on economy policy, is hinting heavily at the need for currency realignment.

In a report released this week, it said “current policies and the assumed constellation of exchange rates may not be sufficient for the needed rebalancing of demand.”

It added that policy reforms by the world’s big economies to restore growth “would be more effective if accompanied by a real effective renminbi appreciation, offset by euro and dollar depreciation”.

An international understanding on dollar depreciation may well not be reached in Pittsburgh. A French official said last Friday that Pittsburgh would merely set the stage for future talks on foreign exchange rates.

“At this stage there will not be currency discussions, but the framework that we hope to put in place…is a way of discussing later the question of exchange rates,” said the official, who declined to be named.

But giving China and other developing countries more power in the IMF and the World Bank could be part of an informal quid pro quo in which China quietly undertook to resume appreciating the yuan against the dollar.

The rise of the euro as high as $1.4821, breaking the December 2008 peak of $1.4719, is a technical signal that the market thinks the dollar is increasingly vulnerable.

For many traders, the break suggests a good chance of a rise to at least the psychologically important level of $1.50 in coming weeks or months.

The European Central Bank might seek to limit speculation against the dollar by expressing concern about such a move. But the market does not appear to worry that the ECB could actually intervene to support the dollar.

When the European Union’s Economic and Monetary Affairs Commissioner Joaquin Almunia said last week that excessive appreciation of the euro could hurt Europe’s economy, the euro fell back only marginally and briefly.

The market knows that even at levels just above $1.5000, the euro would remain well below its all-time high against the dollar of $1.6038, hit in July 2008.

And any rise of the euro against the dollar in the current circumstances would probably be seen by policymakers as the result of general dollar weakness, not excessive euro strength. When euro/dollar reached its July 2008 peak, euro/yen hit a similar high; now, euro/yen is a full 35 yen lower.

The Japanese may also be willing to see their currency strengthen. Before new Finance Minister Hirohisa Fujii took office this month, he said a strong yen was generally good as it boosted the purchasing power of Japanese.

Fujii subsequently backed away from that comment, but speculation will remain that after sweeping to power last month, the Democratic Party of Japan may try to shift the country away from its reliance on exports and its opposition to yen strength.

In the context of a G20 drive to rebalance the global economy, this could easily cause the market to think the yen should be trading stronger than 90 to the dollar.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

It looks bad for the dollar, but looks can be deceiving.

Its sharp decline in the last week has pushed the euro to its highest level in a year and reignited fears that there’s only one place for the dollar to go, and that’s down.

Rhetoric from influential investors like Warren Buffett as well as big foreign buyers of U.S. debt like China and Russia has fed that sense of doom.

Then there’s the yen-like role of the dollar as the funding currency, which is casting a pall over the buck since the longer the Fed keeps a lid on interest rates, the longer the pressure stays on the currency.

Yet the dollar is still the No. 1 currency stashed in reserves around the world, by a long shot. International Monetary Fund data showed the dollar accounting for 65 percent of total allocated reserves in the first quarter.

That means there’s only so far you can push the currency before the self-interest of the world’s savers kicks in to support the buck.

First a little perspective. The dollar’s decline this year mirrors the rise in risky assets like U.S. junk-rated corporate debt that have returned to valuations seen before Lehman Brother’s implosion. Just as credit markets shut down and money poured into safe-haven U.S. Treasuries, the dollar soared as currency investors viewed it as a place to hunker down until the storm passes.

It may still be cloudy, but investors have been confident enough to venture back into riskier territory like emerging markets, which are booming.

That’s meant less money for U.S. assets. Recent data from the U.S. Treasury confirmed as much when it showed net foreign capital outflows of $97.5 billion in July, up from the exit of $56.8 billion in the previous month.

The Fed’s zero-bound interest rate policy has also turned the dollar into a funding currency, where investors borrow in the low yielding dollar and invest in nations that offer juicier returns.

“The dollar is selling off because we have low interest rates. That’s a macro fact,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.

Yet, unlike the Japanese yen, which also served as a funding currency earlier this decade, the dollar, or rather dollar-denominated assets, continues to be sought after by nations with big reserves like China and Japan.

Brown Bothers Harriman notes that China snapped up $21.5 billion of such assets in July while Japan added $19.25 billion. Russia and Brazil, which are also sitting on stockpiles of reserves, trimmed their holdings by a relatively small amount.

This is significant. Earlier this year, China and Russia spooked currency markets when they began talking about the need for an alternative to the dollar for the world’s currency reserves.

Such an alternative would help savers like China better protect the value of their assets should the dollar fall out of favor, as it is now. Yet it could take years if not decades to implement.

That means the dollar is still the only game in town, rightly or wrongly, which should provide some comfort to those fearing the worst — a dollar in freefall without a net.

- John Kemp is a Reuters columnist. The views expressed are his own. -

Reports that China has asked for a discussion about reserve currencies at next week's expanded Group of Eight summit in Italy has added to confusion about whether the country wants to dethrone the dollar from its status as the world's sole reserve currency. But the very fact the issue has been pushed onto the agenda suggests that a fundamental shift is underway.

Given the U.S. government's enormous borrowing requirements over the next decade to cover the bank bailout, fiscal stimulus and deficits in Social Security and Medicare, the dollar's reserve status depends on emerging markets' continued willingness to accumulate U.S. liabilities rather than switching to other stores of value, such as the euro or the IMF's Special Drawing Right (SDR).

As the largest buyer of U.S. Treasury securities, China can break the dollar's reserve currency status any time it wants. But it would risk large losses on the stock of U.S. debt that it has bought already. The resulting unstable stability is the foreign exchange version of the Cold War stalemate based on "mutually assured destruction".

Senior Chinese officials have given off mixed signals about their intentions.

When pressed, officials have indicated China will continue to stand by the dollar in the short term and denied the country has begun to diversify its official holdings. But that has not stopped People's Bank of China (PBOC) Governor Zhou Xiaochuan floating the idea of shifting to a super-sovereign currency based around the SDR.

Zhou's call for diversification was repeated last week in the central bank's annual stability report, which noted that "an international monetary system dominated by a single sovereign currency has intensified the concentration of risk and spread of the crisis". It went on to urge the IMF to exercise closer supervision of the economic and financial policies of major reserve-issuing countries.

Chinese officials have bluntly expressed concern about U.S. fiscal and monetary policies that appear to contemplate inflation and devaluation as a way out of the debt crisis, or at least accept it with weary resignation.

China has started backing a variety of small projects designed to encourage greater "internationalisation" of its currency (such as an active RMB market in Hong Kong and bilateral discussions with Latin American countries on the use of RMB to settle trade transactions).

The question is whether China is preparing to deliver the "coup de grace".

Pressing for a reserve currency discussion at the expanded G8 summit (which will also be attended by India, Brazil, Mexico, South Africa and Egypt) suggests China's leaders are serious. They must have known that just pushing the issue onto the agenda would rekindle market fears about the dollar's value.

But it could also be an attempt to create leverage and seize the initiative as part of wider efforts to shape the international financial agenda.

In the past, G8 summits have been structured as a monologue from the advanced industrial economies to the developing world. But following the debt crisis, the leading emerging markets are in no mood to be lectured.

By putting the dollar into play, China's government may hope to pre-empt pressure from western countries for a revaluation of the RMB, and take exchange rate discussions off the table entirely.
It is also a sign China is ready to begin flexing its financial muscle and will have to be treated as an equal alongside the United States, EU and Japan, shaping as much as responding to the policy debate.

The dollar's reserve status has become highly conditional, one of a number of items to be bargained over as part of the international financial agenda. Past experience suggests that when reserve currencies become highly contingent in this way, it marks the beginning of the end.

The dollar will not lose its reserve status completely. But it is set to become less "special". In future it will have to share its reserve status with the euro, the yen and perhaps even in time the yuan.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The dollar is, and will remain, the U.S.’s currency and its own and everyone else’s problem.

The idea of creating a global currency, as espoused by China earlier this week, is interesting, has a certain amount of merit and is simply not going to happen any time soon.

U.S. desire for free access to the cookie jar that being the world’s reserve currency represents will be too strong, especially given its need to finance huge amounts of debt reasonably cheaply. As well practicalities are fearsome, even if consensus was more or less there.

Chinese central bank head Zhou Xiaochuan on Monday called for the creation of a new “super-sovereign” global reserve currency, advocating building on an International Monetary Fund instrument called Special Drawing Rights.

Zhou echoed a call by Russia last week, when it indicated it would raise the issue at the upcoming Group of 20 meeting in London on April 2, saying the idea had support from emerging market economies including Brazil, India, South Korea and South Africa.

There is no doubt that the current system breeds instability, but it enjoys the great advantage of entrenchment and sticking with it allows the U.S., and others, to avoid making hard choices and paying true market prices for their economic decisions.

No surprise then that President Obama knocked the idea down in blunt terms. “I don’t believe that there’s a need for a global currency,” Obama said, terming the dollar “extraordinarily strong right now.”

Exactly. Too strong by some margin, especially when one considers the coming effects of both quantitative easing and a massive long-term need to fund the costs of the debt binge that exploded and the ever increasing bailout to clean up the aftermath.

In fact you could say the dollar’s “extraordinary” strength can only be fully explained when you take into account the fact that foreign central banks keep piling up huge reserves of the thing and that it is the international medium of exchange for commodities and energy, well really for global trade and financial intermediation.

Treasury Secretary Timothy Geithner said on Wednesday the U.S. dollar is still the world’s reserve currency and will remain so for a long time, but expressed openness to greater use of IMF SDRs.

The dollar’s central role has two main implications, both rather ugly but also very seductive for those involved.

For the U.S. it’s a bit of a free ride as far as debt financing goes. People buy and hold treasuries more and the U.S. gets cheaper financing that would otherwise be the case. Of course that’s a bit like an alcoholic bartender getting a discount at work; a real benefit, but not a true one.

It also means that even if the U.S. has the will to take away the proverbial punchbowl or drive the dollar down, it doesn’t always have control, as what it does at the short end of the interest rate curve can be confounded by foreign purchases that keep the long end and financing costs down and the dollar up.

SOVEREIGN OVER US ALL?

The U.S. reserve status also opens up the opportunity for mercantilist countries, like, say China, to keep its own currency cheap, building up huge dollar stocks and force-feeding the American milch cow with cheap credit with which to buy imported goods.

That may not work any more anyway, as all of the cow’s stomachs are full and the milk’s gone thin.
There is a temptation also to build up reserves as protection against bad times and bitter IMF medicine.

Many Asian leaders seem to have vowed after 1997 that they would do what was needed, which often included building up dollar reserves, to avoid having to meet an IMF director’s plane at the airport and accept the accompanying prescription.

That rather indicates that the old system, with the U.S. as global reserve currency, is dying, but I doubt it will do so without a fight and with cooperation among nations willing to cede part of their sovereignty, even for a greater good.

It is amazing and encouraging that China speaks of ceding control of a portion of its foreign reserve assets to IMF management, but I have a hard time seeing it happening widely soon.

So, we will have to get through the next year or two without a super-sovereign currency and with global imbalances being worked out, or around, under the current system.

My best guess is that things actually go in the right direction, more or less. The dollar should weaken as a result of U.S. policy even without a deliberate push downhill from the Chinese. Asian exporting nations will see slowing reserve growth generally, which should translate into diminished flows into the dollar and Treasuries.

That’s going to be painful all around. The Chinese and others will see their investments dwindle, even as they have to resist the impulse to sell into the fall. For the U.S. the process of implementing monetary policy and paying for fiscal policy will be made that much more difficult.

So, goodbye and perhaps good riddance to dollar hegemony, but don’t expect a stable system of global cooperation to rise easily and quickly in its place.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– John Kemp is a Reuters columnist. The opinions expressed are his own –

Perhaps the most surprising development over the last three months has been the surging value of the currency at the heart of the crisis. It is almost as if investors have responded to a fire alarm by running towards the source of the fire.

From a recent low on July 15, the U.S. dollar’s trade-weighted value has risen 19 percent. The dollar has been broadly stable against China’s yuan (+1 percent) while posting massive gains against the Swiss franc (+20 percent), the euro (+26 percent), the British pound (+35 percent) and the Australian dollar (+52 percent). Only against Japan’s yen has the currency slipped marginally (-6 percent).

Since 1997, commentators and policymakers have openly worried about America’s gaping trade deficit, resulting dependence on foreign capital inflows, and the risk of a sharp correction in the value of both U.S. government bonds and the currency if investors started to balk at financing the resulting payments gap.

The economy’s expansion witnessed a large decline in the dollar’s value by almost 40 percent between Feb 2002 and March 2008. As the crisis intensified and the U.S. slipped towards recession, commentators and policymakers raised a renewed alarm about a possible currency collapse.

Instead, the dollar has witnessed its most broad-based and sustained appreciation since the late 1990s. In the last month, the currency has traded at its highest level against the euro for two years.

ADJUSTMENT BY RECESSION

For 10 years, the widening deficit in the current account of the U.S. balance of payments has been the main source of perceived dollar risk. The deficit ballooned from $125 billion in 1996 (1.6 percent of GDP) to $788 billion by 2006 (6.0 percent of GDP).

Persistent deficits in the trade balance could not be covered by a moderately positive net inflow of profits, interest and dividend earnings from abroad. So the United States resorted to massive sales of government and private debt (including U.S. Treasuries and securitized mortgages), corporate equities, whole companies, and other forms of real property to foreigners to fund the import surge.

The financing requirement absorbed more than half of all funds that investors worldwide made available for investing outside their home country. The net external debt of the United States quintupled in just a decade from $456 billion in 1996 (5.8 percent of GDP) to a staggering $2.442 trillion in 2007 (18 percent of GDP).

It is a moot point whether the deficit in the current account spurred the issuance of record quantities of often poor-quality debt (as critics of the Federal Reserve have charged); or whether a global savings glut coupled with strong overseas appetite for U.S. assets created a capital account surplus and forced the United States to run a large trade deficit (as Fed Chairman Ben Bernanke has claimed).

In reality, the balance of payments is an integrated whole and part of the wider international flow of funds. China’s willingness to lend (by accumulating reserve assets) found ready willingness to borrow in the United States (mostly to fund consumption and a massive build out of new homes). The end result is that China has ended up owning a lot of U.S. government paper, and the U.S. has ended up owing a lot of money.

Policymakers have warned for more than a decade that these “global imbalances” were unsustainable and would eventually need to be reversed. The hope was adjustment would come about mainly through a significant but orderly devaluation of the dollar and rise in U.S. exports, rather than a deep recession in the United States that would cut import demand.

In the end, policymakers have been spared the choice.

The unfolding credit crisis is producing a deep recession, cutting U.S. demand for imports, and forcing the long-overdue adjustment in the trade deficit. Because the recession is centered on the United States, U.S. import demand is falling more rapidly than the demand for the country’s exports in Europe, Asia and the rest of the world, producing the necessary current account adjustment.

It is a bitter irony that recession has removed one of the main sources of downward pressure on the U.S. currency.

SLOWING CAPITAL OUTFLOWS

Only a minority of the financial resources obtained from the rest of the world in recent years have been used to fund the current account deficit. Most have been used to pay for the acquisition of other assets overseas.

According to the “Flow of Funds Accounts of the United States”, published by the Federal Reserve (Table F.107), the United States obtained about $3.5 trillion in funding from overseas investors in 2006-2007. But of this total, less than half was used to finance the current account deficit ($1.5 trillion). The remainder ($2 trillion) financed the acquisition of other assets overseas.

U.S. residents went on a buying spree for around $399 billion worth of foreign bonds, $255 billion worth of foreign equities, and almost $575 billion worth of overseas company takeovers. Since the United States was not generating a current surplus to pay for these acquisitions, they were, in effect, being financed by borrowing money from abroad.

But as the credit crunch intensifies, net acquisitions of overseas assets by U.S. residents have slowed abruptly. Net acquisitions have halved from an annualised rate of $812 billion in Q3 2007 to $399 billion in Q1 2008; and in Q2 U.S. residents actually disposed of $41 billion worth of foreign assets on a net basis.

As U.S. residents invest less abroad, their need to attract foreign financing to cover the payment gap in the absence of a current account surplus will diminish. Financial crisis and recession have therefore made a balance of payments crisis less likely on the capital-account side as well as the current-account one.

OFFICIAL RESERVE POLICIES

Looking forward, the main risk to the U.S. currency comes from the need to place substantial amounts of U.S. Treasury paper in the market over the next two years to finance the cost of financial rescues and the incoming administration’s proposed fiscal stimulus. Funding of as much as $3-4 trillion will be needed in fiscal 2009 with further substantial requirements in fiscal 2010.

Foreign buyers have absorbed more than half of the Treasury securities issued to the public in recent years. If they balk, the currency could come under sustained pressure.

But foreign governments and central banks have been much more important buyers of Treasuries and agency securities ($706 billion in 2006-2007) than foreign private investors ($160 billion). The motivations of foreign buyers are not strictly commercial.

China and other official holders of U.S. Treasuries and agency securities have the most to lose from any crisis of confidence that sparked a fall in bond prices or a decline in the dollar. China and the other big reserve holders need to carry on lending new money to hold yields down and protect the valuation of their legacy stock of assets.

Foreign asset holders might decide to stop throwing good money after bad, and risk taking a one-time hit on the value of their existing Treasury holdings from a rise in yields or a dollar devaluation. But all the signs are that they will continue lending into weakness instead.

Over the last three months, foreign official holdings of U.S. Treasury and agency securities in the custody of the Federal Reserve Banks have risen more than $100 billion (with a rise in Treasury holdings more than offsetting a decline in agency bonds).

With recession taking care of the current account deficit, financial crisis reducing gross capital outflows, and foreign official buyers continuing to support the Treasury market, the U.S. currency has been a strange beneficiary of the crisis. If the dollar’s earlier decline was a symptom of over-fast growth, its rise is a by-product of recession.

Juan Enriquez is managing director of Excel Medical Ventures and the author of “As The Future Catches You.” Any opinions expressed are his own.

There are two ways of viewing this debt crisis. One is that it is simply a temporary dislocation in the credit markets and a liquidity problem. The second is that it is a crisis triggered by subprime lending, accentuated because most people still can’t afford their houses, and compounded because almost every bad loan was highly leveraged. If it is the second type of crisis, one should remember: if trapped in a ditch full of debt, quit digging.

We are piling debt on debt. U.S. consumers are tapped out. Net household savings have gone negative. Corporate debt, particularly derivatives exposure, has reached truly dangerous levels. (Outstanding derivatives exceed $655 trillion. The U.S. economy is around $13 trillion). Government indebtedness is also approaching levels that exceed even those reached in the Depression and World War II. Add these three sources of debt together and the U.S. already owes almost four times its GDP. Now we are adding trillions in bailouts and face rocket-fueled mandatory spending programs. These trends may end up being fatal if we do not act. Right now.

For years, many have been warning, pleading, threatening. Now the crisis really is upon us. And because the numbers are so large, the Obama administration has a very narrow window, say thirty to sixty days, to send ten very clear signals and buy itself some financial breathing room.

First and foremost, Obama has to focus on the dollar. There is ever more pressure on rating agencies to question whether the U.S. remains a triple AAA credit risk given the current debt overhang. If U.S. debt is downgraded then a whole series of institutions could not hold T Bills and short sellers would begin to hunt. Maybe some of the same ones that brought down the British pound.

We have to send a very clear signal that we are going to begin to live within our means, spend what we earn, eventually begin to save. This requires a bipartisan program that makes both Democrats and Republicans most unhappy as we begin to restructure our debt.

We cannot save every dying whale. Everyone wants a handout. Some are essential. But we simply cannot afford most bailouts. We cannot spend a few hundred billion more, every week, without major consequences. Some banks, some major companies, cannot be saved.

All entitlements must be fair game. They were going to exceed all government revenues by 2030. The current bailout, guarantees, and supports accelerate this reckoning by five to ten years. We are out of time. So if you are 60 to 65 you probably just lost a good chunk of your nest egg. You get a free pass. 55 to 60? We need a year’s more work out of you before retirement and benefits. Under 55? We will need at least three more years. This is fair given that benefits like Social Security were provided when being 65 was considered old and life expectancy was 68.

The U.S. cannot simply pull out of all military commitments overnight; we already saw the consequences of this in Afghanistan in the 1990s. And even if we did pull out, there are enormous cost overhangs in veteran care and benefits that have to be respected. But at the same time, we cannot afford to maintain the military we have. So there has to be a commitment to cut military spending by 2-3% per year for a decade. If we can do this in the context of mutual disarmament treaties with China and Russia, so much the better.

The greatest single threat to the budget is medical spending and benefits. We currently spend about 17% of GDP but the trends are horrific. And we only spend one out of seven dollars directly on doctors and nurses. There is much to be cut, much to be rationalized. So let’s commit to capping medical costs at 20% of GDP (it is 17% today). Begin by covering essential services first so we do not end up in budget games like: “if you wish, I’ll just shut the emergency room.”

Which brings up the matter of budget transparency… CEOs who exceeded a budget by as much, or hid as much debt, as most governments routinely do would, at best, be fired. More likely they would be jailed. We need to apply a simplified Sarbanes Oxley to business and to state and federal government. We also need to apply some transparency to unregulated markets, like derivatives.
While cutting in some places, the U.S does have to keep fast-growing start ups alive. Venture backed companies invested about 0.2% of U.S. GDP to create close to 18% of the economy. This is where you generate most of the jobs, not in the Fortune 500.

As a last, and perhaps the most important commandment and priority, the financial crisis will pass. But the long term survival of the country depends on treating education like a varsity sport. If you want to play varsity you have to put in the twice daily practices, summer training, hire the best coaches, move the incompetent aside, and build large organizations of committed parents and boosters. Not everyone can, or even wants to, play varsity, but those who choose to compete should get extraordinary resources.

If the U.S. lets people know it is serious about getting its financial house in order, we will survive and thrive. The alternative that was followed by so many others is just to keep spending, which is why the last thing most great empires do is drive themselves into bankruptcy.

This essay is adapted from a talk that Enriquez gave at the Pop!Tech conference in October. View the video below.

Juan Enriquez (2008) Pop!Tech Pop!Cast from Pop!Tech on Vimeo

Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is a senior fellow at the Hudson Institute. The opinions expressed here are her own.

“The Buck is Back,” proclaimed a Wall Street Journal headline on Tuesday. But even if it is, and that’s a big if, a strong currency is a mixed blessing.

True, in spite of the financial crisis, over the past six weeks the dollar has strengthened substantially against the euro and the British pound, although Wednesday’s half percentage point Federal Reserve rate cut caused the dollar to slip. But the dollar has lost value relative to the Japanese yen.

What’s really happening is not that the dollar is strengthening on its merits, but that European currencies are weakening.

“For the dollar to depreciate, it has to depreciate against another currency. America isn’t looking great, but Europe is looking even worse,” explains American Enterprise Institute resident fellow Desmond Lachman.

Europe’s worsening economic problems — greater than America’s — are causing some investors and the army of regular foreign exchange speculators to prefer dollar assets, what foreign exchange traders call a “flight to quality.”

Approximately 40 percent of America’s subprime loans are held abroad; the British housing market is deteriorating; the British government is bailing out the City of London’s famed banking sector; and European banks hold risky investments in slowing Eastern European economies, especially Russia.

As a result, the European Central Bank is likely to cut interest rates soon, further dimming the attractiveness of the euro, and the Bank of England may well follow suit.

Although a stronger dollar might appeal to Americans’ patriotism and pride, it will have mixed consequences. It makes exports more expensive and imports cheaper, which implies lower economic growth and a loss of jobs in export industries.

The relative weakening of European currencies versus the dollar could hurt America more than Europeans.

America’s 2.8 percent annualized second quarter GDP growth rate was supported by exports, and third quarter GDP would have declined by more than three tenths of a percent without them. As consumers reduced spending, rising exports helped employment.

With a weaker currency, Europeans will see more Americans visiting for vacations and shopping trips, and it will be easier for Europeans to sell their products in American stores for Christmas — if the recession doesn’t completely empty the stores of shoppers.

Japan, with its strong currency, is the country that may be in real trouble. With interest rates in Japan only at 0.3 percent, reduced on Friday from 0.5 percent, the Bank of Japan has little room to cut to let the yen fall against the dollar and the euro. In addition, its low interest rate makes the yen the currency of choice for hedge funds, which borrow yen and invest in euro- or dollar-denominated assets.

No wonder, then, that, shares in export-oriented Sony have fallen 68 percent this year, and that the Nikkei stock market index has declined by 56 percent.

Some, such as Encima Global President David Malpass, criticize Washington for not doing more to promote a stronger dollar. The weak dollar, according to Malpass, was one of the major causes of the financial crisis, resulting in inflation, the asset price bubbles in commodities and housing, and withdrawal of capital from America. Although America benefited from exports, this was outweighed by damage done to other sectors of the economy.

Yet with the economy in recession, the Fed won’t raise interest rates soon to strengthen the dollar. Domestic considerations trump the dollar in determining economy policy.

As the global economy works its way out of a recession, Japan, with its strong yen, has more to lose than Europe, with its weak euro. As for the buck, it is not back, but it is fine where it is.

You can contact the author at dfr@hudson.org