DOLLAR'S DOWNWARD SPIRAL

Kuwait’s decision to detach its currency the dinar from the US dollar could be another signpost on a downward spiral leading to the dollar’s inevitable collapse as a reliable global currency.
Kuwait’s willingness to break away from other US Gulf allies who have pegged their currencies to the dollar came in the wake of the declining value of the dollar in relation to the euro and other major currencies. Kuwait’s Central Bank felt that the longer it relied on the dollar to keep the dinar strong the more vulnerable the dinar would be to speculators. It also believed the country’s inflation rate would continue to rise.
The move by Kuwait also marked a sharp departure from a strategy used for over two decades by countries awash with US dollars. The prevailing conviction was that being pegged to the dollar or buying US debt in the form of US Treasury Bills were hedges against speculators attacking a nation’s currency. The conviction went something like this. When speculators attack your currency they buy massive quantities of it and pull it off the market thereby making it so scarce its value shoots up and it quickly becomes a valuable commodity investors want to purchase. The moment speculators see its value soar they sell of their massive stocks of it and make a huge “killing.” However, by putting so much of your currency back on the market they quickly force down its value. Therefore the only you can protect your currency from plummeting to a zero value is to use your dollar reserves to go into the market to buy up as much of your own currency as you can. Having done that you pull a sizeable quantity of your currency off the market to stabilize its overall value.
George Soros the billionaire speculator went after the English pound in this way in 1992 and its value crashed forcing Britain to devalue. To avoid that catastrophe, countries began buying US Treasury Bills, which in effect meant they were not just buying dollars as an investment and a protection mechanism, they were buying US debt. Nevertheless, it put them in a position whereby they had large reserves of dollars to protect their own currency when it was attacked by speculators. That had the effect of deterring speculators but now that the dollar itself is weak countries like Kuwait feel it offers sparse protection in a financial crisis and is not a good long term investment. While the Kuwait episode is a sign of the dollar’s growing problems, there are greater problems on the horizon.
Since 2002 the dollar has fallen 25% in value on the international markets and last year a strategist for one of the major banks commented that the dollar was “going to hell in a handbag.” The basic problem is that for more than two decades the US has been importing far more than it has been exporting. The difference in value between what we buy in and what we manufacture at home and sell abroad is known as the current account. That account in 2006 had a deficit of almost $800 billion, meaning we bought that amount of good and services more than what we sold overseas. Our current account deficit stands at approximately $15 trillion. If this was any country other than the United States the IMF would be demanding the type of stringent curbs on our spending and economic policies that it has previously sought from poorer countries, especially in Latin America.
In order for the US to keep running such a massive current account deficit it must have money to keep the economy functioning. To get that money it sells US Treasury Bills to countries like China. The Chinese are only too happy to buy the Bills because they know the money they pay for them finds its way into the hands of American consumers and as long as American consumers are flush with money they will continue to buy approximately 25% of China’s exports. It is estimated China holds approximately $900 billions in Treasury Bills from which it constantly earns interest from the US. All of that provides China with a considerable amount of economic clout and political leverage when bargaining with Washington.
For its part, the Bush Administration has been happy to see the dollar plummet in the belief it makes US exports more competitive thereby producing greater internal growth and ultimately slowing the volume of imports, especially from China. The argument goes that this will eventually reduce the size of our current account deficit.
That is all very well until one looks at the bigger picture of a declining dollar and the fact that an international crisis or a dollar hitting zero value could trigger a doomsday economic scenario for the US economy. If China was on the verge of a conflict with the US it could flood the global market with dollars and demand the US allow it to cash out almost $1 trillion in Treasury Bills. Other countries like Russia, Japan and even Iran would be likely to follow suit. Such a move could send the US economy into freefall.
The dollar hitting a zero vale is a nightmare scenario that is not so far fetched. We Americans are living on borrowed money from foreign purchasers of our Treasury Bills and it is estimated we borrow approximately $3 billion per day. As a consequence, we are paying hundreds of billions of dollars each year on interest accruing from our national debt.
The IMF, not for the first time, has warned the US about its increasing debt and some experts have speculated that if steps are not taken to rein in Chinese imports and increase our manufacturing base the debt could reach almost 50% of our GDP. Such a situation would be unsustainable.
The most worrying aspect of the dollar’s decline is just how much the destiny of the dollar is in the hands of others, especially Russia and China. They hold in reserve so many dollars that if they decided the euro was the better currency and sold off their dollars the US would be weakened economically and politically.
Much of the dollar’s strength since the early 1970s has relied on the fact that it has been the global currency for buying and selling oil and gas. Known as the Petro-Dollar it has been the currency favored by Central Banks for energy deals. If the US and Russia headed back into a Cold War relationship, Russia which holds the world’s largest gas and oil reserves, could opt for the Petro-Euro. China would follow Russia’s lead and so too Iran with its sizeable reserves of gas and oil. That would result in a collapse of the dollar as a reliable international currency. It is with that in mind that many experts argue the US should long ago have used its technological expertise to develop alternative energy sources. But the US has plummeted as a world competitor in the field of technology. In 1990, we were exporting tens of billions of dollars more in advanced technology items than we were importing. Now it is the other way round and we have a negative balance vis a vis what we export and what we import in that sector of the economy.
China has been happy with the state of the dollar because its weakness and our poor manufacturing output have meant that the Chinese have controlled our destiny. They continue to pay us to buy their cheap products so that they can grow into a superpower. The closer they reach that goal the more likely they may not need to rely so much on a weak dollar and US consumers. The Chinese Central Bank has hinted in the past year that if the dollar continues to slide and the US current account deficit grows to almost 40% of our GDP international investors may not feel it is worthwhile to buy US Treasury Bills. Coming from the Chinese, who have deliberately kept their currency low in order to sell us cheap imports, that is the height of hypocrisy. But it is a measure of Chinese confidence that China can tell the US to get its act together. After all, China wants to continue to milk the golden cow while it moves inorexably to superpower status.