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Tuesday, March 29, 2005

Will the U.S. Dollar Be the Source of the Next Global Economic Crisis?

Peter Drucker, writing in The National Interest, says "yes".

The next major economic crisis will most probably be a crisis of the U.S. dollar in the world economy. It will put to a severe test the oligopoly of the central banks of the developed countries that now rules over the world financial economy.

Sixty years ago, in the Bretton Woods meetings of 1944, which tried to refashion a world economy that had been devastated by depression and war, John Maynard Keynes, the 20th century's greatest economist, proposed a supra-national central bank. It was vetoed by the United States. The two institutions that Bretton Woods established instead, the Bank for International Development (World Bank) and the international Monetary Fund (IMF), are, despite their impressive names, auxiliary rather than central--the former mainly financing development projects, the latter providing financial first aid to
governments in distress.

The Bretton Woods system was never the stable, "non-political" system Keynes wanted. It could not and did not prevent currencies from being overvalued or undervalued. Still, although it limped from one crisis to the next, the Bretton Woods system worked for most of the half-century after World War II. And there was only one reason why it worked (however poorly): the commitment to it of the United States and the strength of the U.S. dollar as the world's key currency.

The dollar is still the world's key currency. But the Bretton Woods system is being killed by the U.S. government deficit, which is fast becoming the sinkhole of the world financial economy. The persistent U.S. deficit creates a persistent deficit in the U.S. balance of payments, which make both the U.S. economy and the government increasingly dependent on massive injections of short-term and panic-prone money from abroad. The U.S. savings rate is barely high enough to finance the minimum capital needs of industry. It could, in all likelihood, be raised considerably by raising interest rates. But that is not only politically almost impossible; it would also require that a larger share of incomes go into savings rather than into consumption, with an inevitable collapse of an economy based on consumer spending and low interest rates, as for instance, the U.S. housing market.

The government deficit is therefore being financed almost in its entirety by foreign investments in the United States, mostly in government securities like short-term treasury notes and medium-term bonds. The Japanese are converting most, if not all, of their trade surplus with the United States into dollar-denominated U.S. government securities and have thus become the largest U.S. creditor.

... The economic fact is that the United States increasingly borrows short term (U.S. securities can be sold overnight) to invest long term and with very limited liquidity. This, needless to say, is an unstable and volatile system. It would collapse if the foreign holders of U.S. government securities (above all, the Japanese) were for whatever reason (such as a crash in their own economy) to dump their holdings of U.S. government securities. ...

I have written about this potential problem before. My question to Mr. Drucker is, as I asked before, "If foreign central banks decide to hold fewer U.S. dollar-denominated securities, what will they decide to hold more of? Probably not Euros."

Is George Soros shorting the U.S. dollar? If so, what is he buying/holding?

Update: for a fascinating debate on this topic, see here, a Wall Street Journal econoblog debate between Nouriel Roubini and David Altig . My position? I can easily be persuaded that either position is correct. Both seem concerned about the massive U.S. gubmnt deficits.
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