Global Policy Forum

By Dinkar Ayilavarapu

When Mohammed Atta and company flew their planes into the World Trade Center, the symbol of America's economic power, they might well have not seen the impact the tragedy was going to have on that other symbol of American power, the dollar. Much has been written about how September 11, 2001 affected the American economy, but the associated wars and military operations in the "war against terrorism" are also having a major impact on the status of the US dollar, with substantial damage likely.

A sick greenback

It wasn't like the dollar wasn't already sick. America has a current account deficit to kill for. It stood at US$462 billion, or about 4.7 percent of GDP in the third quarter 2002. This is expected to hit the 5 percent mark in early 2003.

To understand its significance, let's consider a household that is consuming more than it is earning (or producing). To pay for the extra consumption, it has to borrow as much as is overspent. Or in some cases, sell some of its assets. The current account deficit is like the excess consumption, and to pay for that a country has to borrow from abroad, which it does by running an equivalent capital account surplus. This capital account surplus (or the capital flowing in from abroad) can either be by borrowing from abroad or by selling domestic assets, just like our overspending householder.

Now consider the nightmare situation of nobody willing to buy the householder's assets or willing to lend. Then the householder is in a fix. He would just have to start earning more to pay for the extra consumption (or start consuming less).

This he can do by charging less for whatever he does, and thus getting more work, and in the process overall make more money. Similarly, in the economy, if there aren't enough foreigners to pump money for your benefit, you either have to export more or start importing less. And to do this the currency starts depreciating, making your exports cheaper and imports more expensive, thus reducing the current account gap.

America is running the largest current account deficit ever seen. And if it doesn't find enough foreigners to invest at home, the dollar might well have to take a knock. And attracting money isn't easy given the plunging interest rates. Add to this a sluggish US economy, which will make it progressively tougher to attract foreign investors. According to Stephen Roach, the chief economist at Morgan Stanley, this situation can't go on forever. And according to Herbert Stein's Law, things that can't go on forever don't. America has been there before. In 1985, when the current account deficit was less than it is now (as a percentage of GDP), a revision in market perceptions caused the dollar to drop from 240 to 140 against the yen and 3.3 to 1.8 against the Deutsche Mark.

That the dollar is sick and losing ground is shown by the fact that in the past year it has lost about 14 percent of its value on the trade weighted basis.

Dollar vs euro: A losing battle

As the chart indicates, the dollar has fallen from about 1.10 to the euro in May last year to touch 90 cents to the euro in March.

The war to save the dollar

Among the many theories on why the US is attacking Iraq is the dollar theory. The dollar derives its strength from the fact that the world trusts it over all other currencies. So even in the post Bretton Woods floating rate world, the dollar is a hard currency which central banks around the world hold as their reserve asset.

With the coming of the euro, which is backed by the third, fifth and sixth largest economies of the world, the dollar was threatened. But in the very near term, with the euro zone teetering on the edge of recession and deflation; it doesn't pose much of a threat to the dollar. The uncertainty associated with the new currency also prevented the dollar from being dethroned from its royal perch.

Saddam Hussein did his bit in weakening the dollar when he switched from selling his oil in dollars to doing so in euros. This he did as a statement of anti-Americanism. Iran is planning to make this transition to euros and even Venezuela is open to selling its oil in euros as opposed to dollars. It is also true that the Saudis are open to trading in both dollars and euros.

So there might have emerged a situation where a very large part of the oil in the world would have traded in euros, and not against dollars. This would have weakened the dollar's position as the world's reserve currency. Countries around the world would start switching to euros, and thus weaken the dollar. So it is claimed by some that America, which obviously benefits most from a strong dollar, was fighting to dethrone Saddam (and possibly Iran at a future date) to prevent the dollar from losing ground.

Add to this another theory about how Gulf War II is the solution for the economic trough in which America finds itself since the roaring 1990s - after all, World War II was needed to pull America out of the Great Depression of the 1930s. The Iraq war is supposed to be the great Keynesian adventure of the essentially neoconservative regime of George W Bush. In essence, the fighting in Iraq is supposed to be an economic bonanza for America - loads of oil, billions of dollars of reconstruction contracts, a big government push for the sluggish economy and the removal of irritants to dollar domination.

But look what the war has done

It may well not have been a war to save the dollar and the economy, because it doesn't seem to be doing so. In the short term, the dollar might get hit hard. The war raises two crucial questions - how will it be paid for? And what will it do to oil prices?

The oil question is significant because it has a major influence on the previously-mentioned current account deficit. Since America imports a substantial amount of oil, an increase in prices would widen the current account deficit that America is running. That would make it a lot tougher, if not impossible, for the US to attract foreign investment to plug the enlarged deficit. The dollar in such a situation might be in for a major market-led correction in value.

The Center for Strategic and International Studies (CSIS) in Washington DC in November last year talked of three war cases - the benign case, the intermediate case and the worst case. This classification was on the basis of how the war went and not on how it would affect the US.

The benign case involved a swift coalition victory, and the residents of Baghdad giving the marines a "Kabulesque" reception a la the driving out of the Taliban from Afghanistan. In such a case, with Iraq reviving production within three months and Saudi excess capacity able to weather the storm in the oil market due to Venezuelan and Nigerian disruptions (one due to the Bolivar revolution and the other due to worker discontent), oil prices would be normal by the third quarter. The current account would have been saved. The expectation of such a war pushed oil prices down instantly after the start of the war. But with the slowing advance, prices picked up again in the expectation of a longer, bloodier conflict.

The intermediate case is the more relevant one. In this, the coalition advance meets with resistance by the Republican Guard, there isn't a popular welcome for the soldiers, and no weapons of mass destruction are used. In this scenario the war ends within a few weeks, but guerilla attacks on the coalition forces persist for six months and raise questions about the stability of any new regime. This is the most likely outcome as things stand at present. But nothing can be said until General Tommy Franks is in Baghdad.

In this case, the CSIS predicts that oil prices won't fall below the $30/barrel range well into 2004. But this case needs to be amended - the Rumaylah oil fields in Iraq have been spared any extensive damage and are under coalition control, and the Nigerian oil worker strike has been put off. But even with oil prices in the ball park figure of $30/barrel, the damage to the US current account would be substantial. Let's not start talking about the worst case scenario just yet.

Source: CSIS, background paper - "Oil Price paths under four scenarios", Robert Ebal, Herman Franssen, Larry Goldstein, Adam Sieminski; November 2002

Another way in which oil prices harm the current account is by increasing the prices of goods that America imports. America's major trading partners in the North American Free Trade Area (NAFTA), Latin America and East Asia are heavily dependent on imported oil. So an oil price spike increases their costs of production, which is then passed on to the Americans who buy those goods. As a result, again the current account deficit gets bigger. We must note that this effect gets dampened by the higher prices that US exports fetch.

The budget is broke

Bush sent to congress an estimate of the cost of this war - $74.7 billion. The Congressional Budget Office is a little less optimistic, it prices the war and a two year occupation at $134 billion. Yale economist William Nordhaus goes further and prices the war between $100 billion and $600 billion, over a decade. And economist Martin Wolf, at the Financial Times, costs the war at between $156 billion and $755 billion over the next decade. Wars sure don't come cheap.

The problems with this war bill (like all others as well) is how to pay them. The previous Gulf war was paid for in part by the allies and other gulf states. This one, like the one in Vietnam, might have to be paid by Uncle Sam. The Bush administration has a tough choice to make - it either has to raise this kind of cash through taxes, which the way things have gone with the Bush tax reform is surely not likely to happen. So the other option is to borrow. Raising this kind of money domestically through the savings-starved American economy would dry up the credit available for commercial lending and put upward pressure on interest rates. It was Argentina's need for money to foot its fiscal deficit (along with a peg for its currency) that led to recession.

The third option is to raise the money from abroad. A significant amount of capital flowing into the US has come from the purchase of dollar-denominated US securities by Asian governments. The US must be hoping that continues, otherwise they might have to resort to the last option. The deficits run by the federal government in the 1980s were mostly financed by borrowing abroad. In the 1990s, when the deficits ceased, that borrowing from abroad was used to finance the current account deficit. The borrowing from abroad option increases the indebtedness of America. At present, the debt America owes abroad is $2 trillion, which is about 20 percent of GDP. At the current rate, this debt is likely to cross 65 percent of US GDP by 2010. According to Clyde Prestowitz, author and president of the Economic Strategy Institute, at interest rates of 3 percent it would take $200 billion annually to finance this debt. And guess where interest payments on foreign debt figure in the national income accounts - the current account.

This brings us to the last option - it's called the printing press. The Federal Reserve can in the worst case just get its printing presses rolling. There is nothing like that to get inflation going domestically. A brief visit to Latin America in the 1980s should reconfirm those fears. And more importantly, the dollar is king because of the trust the world has in the Fed. Who would trust the US if it printed dollars to foot its fiscal deficit? If this is resorted to, Saddam Hussein's original aim of undermining the dollar would have been achieved.

What would a weak dollar do?

A weak dollar might not be such a bad thing for many Americans. Exporters around the US would welcome a correction because it would make US goods cheaper and more competitive. But for many more Americans, a weak dollar means expensive imports. Throughout the 1990s, the manufacturing of many industrial and consumer products was exported to locations in Asia. And America imported toys, clothes, electronics and many other cheap things. A weak dollar would push these prices up and cause inflation domestically. Too much inflation, of course, is not liked by consumers and can in the long term could stunt economic growth in America.

In the rest of the world, especially in the export-oriented South and East Asian nations, a weak dollar would be a disaster. America consumes most of their products and a weak dollar would harm American imports. Already, these nations are running scared of China, which makes goods cheaper than they do. This has the potential of knocking off some of the growth these economies are expected to experience. The Chinese won't stay unaffected, but they have a potentially huge domestic market to cater to. Also, a weaker dollar may prompt many central banks around the world to diversify their reserves by buying more euros. That might well mean that European surpluses are exported not to the US (where they have gone in the 1990s) but to the rest of the world - giving the euro zone more influence in the wider world.

The most significant damage a weak dollar might do is to make it more expensive for America to carry out a unilateral demonstration of its technological and military prowess in the world. This might force America to play by the rules more often, and also think a lot more before embarking on adventures abroad. Iraq might be the last hurrah of the hawks for a few years, until the economy is fixed.

America is going to win this war in Iraq. The Americans are already busy doling out the post war reconstruction contracts. Politically, the war will bring about a bonanza - a favorable state in the heart of the Arab world (giving them leeway to cut the Saudis to size), a new reformed UN to do its bidding and oil - enough to send shivers down the spines of aspiring America baiters.

But economically the war might not be such a good thing. Americans might have to consume less from abroad, or sell more of their domestic assets to foreigners. They might have to rely increasingly on the capital-exporting nations of the world, such as Saudi Arabia and China, among others. And this in turn might make American power loom that much less large in the world.

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