Global Policy Forum

By Ibrahim Warde*

George W Bush's visit to Europe last month showed a desire for rapprochement with the members of the EU, even if differences have not disappeared, for example over Iran and arms sales to China. Beijing influences the rate of the dollar, interest rates and the US commercial deficit. The Chinese now hope their financial and economic power will bring diplomat benefit. The value of the dollar, US interest rates and its commercial deficit are dependent, at least in part, on decisions made by and in China. Now the Chinese want to cash in on their financial and economic power, and demand diplomatic privileges.

The former US treasury secretary, John Connally, famously said in 1971, "It's our currency but it's your problem" (1), but it could have been a reference to the dollar policy of President George Bush's first administration. Preoccupied primarily with the war on terror and obsessed with Iraq, policy makers paid scant attention to international economic policy. Certainly, they repeatedly proclaimed their attachment to a strong dollar, to forestall too much speculation against it, but relied on the market to avoid dealing with the twin deficits - budget and trade - that had grown to record heights.

In 2000 the Bush administration inherited a $240bn budget surplus. By 2001 the recession, which reduced tax receipts, plus massive tax cuts voted by a Republican Congress (on the grounds that surpluses were now a permanent part of the economic landscape), and a sharp increase in defence and homeland security expenditure turned a substantial surplus into a huge deficit ($412bn in 2004, 3.6% of GNP). The trade deficit steadily increased over three years, reaching a record $618bn (5.3% of GNP) in 2004 - a 24.4% increase over 2003.

The twin deficit question is discussed at every meeting of the G7 (US, Japan, Germany, France, Britain, Italy and Canada) and at every major international conference. But the proposed solutions entail painful choices (tax increases, lower defence spending, encouragement of saving) that clash with the principal political orientations of the Bush administration.

The US buys 50% more than it sells overseas. Foreign investors, through their acquisition of US treasury bills, sustain the lifestyle of the world's greatest power. Resolving such disequilibria through the dollar policy transfers the costs of adjustments - as growth, jobs and savings - to the rest of the world. A weak dollar makes US products more competitive, US assets cheaper and more attractive to foreigners, and devalues a foreign debt estimated at $3 trillion. It is unusual to be both the world's greatest debtor and the issuer of the world's principal reserve currency.

In 1913 Britain, at the apogee of imperial power, was the world's main creditor. Over the next 50 years it exhausted itself defending, without success and at great cost to its industrial base, the value of the pound. The dollar weapon, which is the current version of what De Gaulle used to call the exorbitant privilege of the US (printing a currency that foreign central banks have no option but to amass), allows the painless reduction of the twin deficits, at least in theory.

Domestic political factors validated such an analysis. In the months before the 2004 US election, every poll indicated that a majority of voters felt that the Democratic senator John Kerry would do a better job of managing the economy. Polls suggested a close election; good numbers on growth and jobs were necessary for the re-election of Bush (the first president since Herbert Hoover in whose term more jobs were lost than created). Only an undervalued currency could produce the necessary good figures.

Dramatic decline

Yet in the weeks after Bush's re-election the dollar's decline greatly accelerated. In December 2004 it kept going down, reaching a historic low of $1.35 to €1 on 24 December. The ritual, though unreliable, end of the year predictions of bankers and economists for 2005 were almost unanimous: it was bound to sink further.

Many factors help explain such a consensus. Bush's re-election raised concerns that foreign policy adventures and fiscal laxity would continue, especially when the president interpreted his slim lead (3%) over his Democratic challenger as a popular mandate for bold and costly initiatives. Bush asserted that he would "spend his political capital" on such controversial policies as the partial privatisation of social security, a measure likely to cost the treasury hundreds of billions of dollars over the next few years.

The failure of the low-dollar policy to dent the trade deficit was another factor. A falling dollar was expected to eliminate the deficit by helping exports and hindering imports. Instead, the gap widened unprecedentedly, highlighting structural impediments. The logical conclusion of the financial markets was that the dollar's decline was too small to matter. A new consensus emerged: to reduce the trade deficit by half, a further 30% decline in the dollar was necessary. It would then be down to €0.55.

Hence the worry of dollar holders, especially those central banks that had supported the currency, and therefore 86% of the trade deficit. Because they kept the greenbacks generated by the US global buying spree, Asian central banks now hold about $2 trillion. Why did China, Japan and others absorb such assets denominated in a falling currency? They were trying to prevent the appreciation of their own currencies, which would have hampered their exports. By investing most of their dollars in treasury bills, these central banks were keeping US interest rates at a historically low level, thus producing the strange cycle in which trade deficits help fund the US budget deficit and make up for its low savings rates.

As the dollar sank further, many central banks began to diversify their reserve currencies, especially by increasing their euro holdings. Such a strategic shift was logical: suffering some losses is one thing; being left holding the baby after a debacle is another. On 19 November the Federal Reserve chairman, Alan Greenspan, warned that foreign investors would soon tire of financing the current account deficit and put their money into other currencies. He said: "It seems persuasive that, given the size of the US current account deficit, a diminished appetite for adding to dollar balances must occur at some point" (2).

A few days later Yu Yongding, a member of the monetary committee of the Chinese central bank, indicated that China had reduced its relative share of US treasury bonds as protection against a weak dollar. The trend was confirmed with the publication of a survey of 67 central banks by Central Banking Publications. It revealed that more than two-thirds had reduced the relative share of dollars in their portfolios in the last four months of 2004. According to one of the authors of the survey, Nick Carver, "Central banks' enthusiasm for the dollar seems to be cooling off . . . The US cannot take support for the dollar for granted" (3). Oil-producing countries are not happy to see a fall in the currency in which their oil is billed. Some of them are starting to shun the US for fear that their holdings may some day be frozen as a result of the war on terror.

No longer ‘other countries' problem'

Foreign exchange policy is at best an inexact science, rife with unintended consequences. At some point, the positive effects of devaluation give way to negative ones. Unable to stem the decline of the dollar, US policy makers have discovered that the dollar weapon is a double-edged sword. When confidence is lost, the dollar is no longer other countries' problem. The expectation of steady devaluation sets off chain reactions: foreign investors demand higher returns to acquire or keep dollars or to buy treasury bills. The steeper the likely tumble, the higher the expected premium in the form of interest rates.

In turn, high interest rates can have a major impact on investment and spending. The real estate sector, greatly favoured by historically low interest rates, would probably collapse. Given the interdependence of economies, a US recession would drag down the world economy.

Europe (and to a lesser extent Japan) has been alone among major powers to suffer the consequences of a weak dollar. The motto of the first president of the European Central Bank (ECB), Wim Duisenberg, was that "a strong euro is good for a strong Europe" (4). Now that his wish has been realised, few in the euro zone are pleased. The current ECB president, Jean-Claude Trichet, bemoans the "brutal" fall of the dollar, which has undermined the competitiveness of European exports. Unsurprisingly, the euro zone had one of the world's lowest growth rates in 2004. Optimists focus on the silver lining: the falling dollar mitigated the impact of soaring oil prices, since oil contracts are negotiated in dollars. As the former French finance minister, Nicolas Sarkozy, said, a high euro "is not only misfortune" (5).

Since China linked its renminbi (currency of the people, the official name of the yuan) to the dollar in 1994, it is making common monetary cause with the US. The dollar's plunge has allowed it to maintain its competitiveness in relation to the US and improve it in relation to the rest of the world. The asymmetry of US-China relations is striking: the US deficit with China is $207bn, more than a third of the total US deficit (6). Public opinion is divided. Some argue that the availability of an ever-growing number of products at rock-bottom prices is a boon to consumers. Wal-Mart, the largest employer in the US, imports some 70% of its merchandise from China. But an increasing number of corporations, workers and politicians now complain about unfair competition and support a more aggressive stance towards China.

Officially, US policy makers, who consider the yuan undervalued by 40%, have called on the Chinese central bank to stop its heavy buying of dollars. China's response has so far been indecipherable. Clearly, the matter is being discussed at the highest levels. Some officials have hinted at loosening, even at eliminating, the dollar peg. Vice-Premier Huang Ju announced that China would reform its currency policy - with the caveat that it would do so cautiously. He also declined to set a timetable, saying that his top priority was the creation of a stable macroeconomic environment. Others dismiss such talk. According to the head of the central bank's monetary policy department, Yi Gang, Beijing intends to maintain its exchange rate policy to preserve stability and promote economic growth. Invited to speak to the G7 finance ministers on 4 February, the central bank governor, Zhou Xiaochuan, refused to address the issue.

Economic powerhouse

The message may be that China is entitled to its monetary sovereignty. Its exceptional growth rates (averaging 9.5% annually between 1997 and 2004) and the enormous potential of its 1.3 billion consumer market have aroused the interest of all multinationals. China has become an economic powerhouse representing 4% of the global economy (in 1976 it was was 1%). It is estimated that by 2020 that figure will rise to 15%.

China is the world's workshop. Although it is not a technological and scientific power, it and the US are the locomotives of the global economy. From outsourcing to the price of raw materials to the recovery of Japan, many crucial aspects of world economy are greatly influenced by China's policies. The acquisition by a Chinese firm, Lenovo, of the personal computer unit of IBM was symbolic of the new role of a country with great ambitions. China has successfully launched over 40 satellites, and plans manned space flights every other year and a moon exploration programme.

Chinese leaders are well aware of the risks of a change in the status quo. Factors provoking instability include high inflation, real estate speculation, a banking sector riddled with bad debt and an underdeveloped capital market. Considering the growing gap between rich and poor, and the absence of democracy, the risks of a political explosion are real (7). Hence the caution of elites worried above all by a sudden slowdown in economic growth, which would have unpredictable economic and political consequences, especially in US-Chinese relations. It is easy to forget China sharply disagrees with the US on many key issues, including Iran, North Korea and Taiwan.

Everybody, except currency speculators, realises that concerted management of the currency problem is preferable to free-for-all policies. Analysts of international monetary relations have adopted a realpolitik perspective focusing on a "monetary mutual assured destruction", joint European-Japanese interventions in currency markets, or a major alliance uniting China and the US against the rest of the world, through which the US will buy Chinese goods in exchange for Chinese financing of US deficits (8).

The possibility that a theoretical threat will be implemented - Japan liquidating a big chunk of its US treasury bills, or the US imposing retaliatory sanctions against China - creates periodic panic in the markets. Joint interventions by the Big Four (US, Europe, China, Japan) based on the Plaza Accord model, are likely to halt speculation and reduce instability. On 22 September 1985 (see opposite) ministers of finance and central bankers representing the G5 (US, Japan, UK, France, West Germany) met to declare the desirability of an orderly rise in currencies other than the dollar. They pledged to work closely to achieve that goal whenever necessary. Thus began, under the leadership of President Ronald Reagan's treasury secretary, James Baker, the controlled decline of the dollar (9).

Today such an agreement is unlikely. Unilateralism and the ideological proclivities of the Bush administration militate against the principle of cooperative intervention. More important, leadership will have to come from Washington and no US government official is in a position to act as forcefully as Baker did. The treasury department was once prestigious and powerful. Bush's first treasury secretary, Paul O'Neill, was seen as too independent-minded and sacked after two years. In his account of his Washington years, O'Neill describes Bush as ignorant of economic matters; at cabinet meetings he was like "a blind man in a room full of deaf people" (10). Since the Iraq war Bush is too preoccupied with great ideological crusades to pay much attention to mundane matters.

Surrounded by yes-men

His November re-election has reinforced his proclivity to surround himself with yes-men. The principal qualification for a political appointment seems to be loyalty, rather than competence. The current treasury secretary, John Snow, is overshadowed by Bush's political advisers. Greenspan, now 79, is in his final year as chairman of the Federal Reserve Board. Whoever succeeds him must achieve the impossible: obtain the absolute confidence of the president and of the markets. Hence the current hazing, with pretenders positioning themselves by defending the indefensible (for example, the wisdom of tax cuts) (11). There is a vacancy of economic power: those who sold the Iraq war and engineered Bush's re-election are also in charge of selling his economic policies.

Since the official start of Bush's second term on 20 January, the attitude toward the twin deficits has changed. The policy of benign neglect has gone too far and there is a real risk of a free fall. Deficits will no longer be reduced by letting the dollar slide, but through rapid economic growth, which will be fuelled by tax cuts. Hence the new discourse: trade deficits are a sign of strength. In the words of Snow, the deficit is a sign that the economy "is growing faster than those of our trading partners in the euro zone and in Japan. The economy is growing, expanding, creating jobs and disposable income, and that shows up in the demand for imports" (12). Similarly, Greenspan no longer talks about the danger of deficits. He now sees market pressures and domestic US forces "which appear poised to stabilise and over the longer run possibly to decrease the US current account deficit and its attendant financing requirements".

The official policy still supports a strong dollar. The difference today is that the government's actions aim to prevent any new slide of the dollar. On 2 February the Federal Reserve raised its federal funds rate by a quarter point to 2.5%, making dollar placements more attractive. (The ECB has kept its rate unchanged at 2 %.) In the communique accompanying the announcement, the Fed stressed the good health of the US economy.

As for the budget deficit, Bush has reiterated his commitment to "reduce the deficit by half". On paper, the 2006 budget is notable for its wide-ranging cuts. Almost every sector, except for defence and homeland security, is affected. Over 150 federal programmes will be eliminated or drastically reduced. Social programmes, particularly those related to children and the indigent, are seriously affected. But the budget rests on fanciful assumptions and excludes the costlier items. Military operations in Afghanistan and Iraq are not included (13). Nor is the cost of the partial privatisation of the social security system, estimated at $754bn over 10 years.

The Bush administration is betting on a sharp rise in revenues, which would be generated by . . . lower taxes. Bush has suggested making temporary tax cuts ($1.8 trillion) permanent. In 2004 tax receipts were only 16.3% of GDP, the lowest level since 1959. In 2000, when the budget had a surplus, the rate was 21%. Vice-President Dick Cheney, who had said that "deficits don't matter" (14), is poised to play a key role in pushing a conservative domestic agenda (15). There is little doubt that his tax cutting zeal will trump Bush's promise to reduce the deficit by half.

1. Barry Eichengreen, Globalizing Capital: A History of the International Monetary System, Princeton University Press, US, 1996.
2. Larry Elliott, "US risks a downhill dollar disaster", The Guardian, London, 22 November 2004.
3. Mark Tran, "Move to euro hits US finances", The Guardian, 24 January 2005.
4. Willem F Duisenberg: "The first lustrum of the ECB", speech at the International Frankfurt Banking Evening, Frankfurt, 16 June 2003, http://www.ecb.int
5. Cécile Prudhomme, Le Monde, Paris, 10 November 2004.
6. David E Sanger, New York Times, 25 January 2005.
7. See Le Monde diplomatique, English language edition, special dossier on China, September 2004.
8. See Eric Le Boucher, Le Monde, 25 January 2004, and Pierre-Antoine Delhommais, Le Monde, 5 January 2005.
9. The dollar, which was worth 4.15fr in the first quarter of 1980, had risen to 9.96fr in the first quarter of 1985. It fell to 7.21fr in the first quarter of 1986 and to 6.13fr in the first quarter of 1987. In marks, the respective values of the dollar were 1.77DM, 3.26DM; then 2.35DM and 1.84DM. See Jean-Marcel Jeanneney and Georges Pujals, eds, Les économies de l'Europe occidentale et leur environnement international de 1972 í  nos jours, Fayard, Paris, 2005.
10. Ron Suskind, The Price of Loyalty: George W Bush, the White House, and the Education of Paul O'Neill, Simon and Schuster, New York, 2004.
11. Paul Krugman, New York Times, 25 January 2005.
12. Elizabeth Becker, New York Times, 13 January 2003.
13. Such costs are unpredictable, and dealt with through separate mechanisms not included in the budget.
14. Ron Suskind, op cit.
15. Jim Hoagland, "Cheney's undimmed role", Washington Post, 10 February 2005.

About the Author: Ibrahim Warde is a professor at the Fletcher School of Law and Diplomacy (Medford, Massachetts) and author of The Financial War on Terror (I B Tauris, London, 2005).

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