The imbalances in the U.S. current account and the decline of the dollar have become a major challenge for the global economy and a matter of concern for foreign leaders. The current account is a broad measure of the trade and financial flows in and out of a country. It displays the difference between what a country spends and what it earns. On the occasion of a recent Franco-German economic meeting in Paris, the finance ministers of France and Germany, Herve Gaymard and Hans Eichel, respectively, called on the U.S. to reduce its "excessive" deficit.¹ Just weeks before, Joseph Yam, chief executive of the Hong Kong Monetary Authority, described the negative U.S. current account as "serious and unsustainable".² Wen Jiabao, the Chinese Prime Minister, added: "Shouldn't the relevant authorities be doing something about this?" So far they have done little.³

The US-current account deficit has widened dramatically within the last decade. Americans have shown a continued trend towards spending far more on imports than they are earning from selling exports. To finance this demand for foreign products, the U.S. borrows from abroad. The U.S. has become the world's biggest debtor with a current account deficit now running at an annual level of more than $600 billion in an $11 trillion U.S. economy. This exceeds the 5% level that economists traditionally consider a benchmark for loss of confidence in a country's currency. It is also well beyond the 2003 level of $530 billion.

But the American deficit problem is not simply over-consumption on the part of the private sector. The public sector is also culpable in this arena. The U.S. government is spending more than it raises in taxes. The difference - $427 billon for the 2005 budget - has to be financed by taking on new debt. The budget deficit widens the gap between national income and national saving and aggravates the deficit in the current account by requiring more borrowing from abroad. Because the budget deficit is so closely related to the current account deficit, the two of them together are commonly referred to as the "twin deficits".

Americans have shown a continued trend towards spending far more on imports than they are earning from selling exports. To finance this demand for foreign products, the U.S. borrows from abroad.

Until now, foreign governments and private lenders have been willing to finance the twin deficits. But, Alan Greenspan, Chairman of the Federal Reserve Board, cautioned recently that international purchases of U.S. assets such as U.S. Treasury bonds cannot continue to increase forever. At a conference held in Germany in late November he said: "Given the size of the deficit, a diminished appetite for adding to dollar balances must occur at some point".⁴

Already the U.S. currency has come under pressure in the financial markets. The dollar has lost more than 20 percent of its value against the Euro since January 2002 and, although it has regained some ground since the beginning of the year, it is expected to fall further.

Some American policy makers welcome this development. The devaluation of the dollar can help to shrink America's trade deficit by increasing the price of imports at home and decreasing the price of exports abroad. But should the demand for U.S. dollars decline too sharply, American interest rates will rise. Only by promising higher returns would the U.S. be able to continue to attract foreign purchases of dollars and other U.S. assets. But with higher interest rates, financing the current account and the budget deficit would become more costly and, in the end, perhaps unsustainable. In this case, a sharp contraction of domestic consumption would be necessary. This would mean another recession in the U.S. economy.

The repercussions of the falling value of the dollar are already being felt in other parts of the world. In Europe, using monthly averages of the exchange rate between the Euro and the dollar, American consumers interested in purchasing a European car worth 15,000 Euro had to spend roughly $19,700 in January 2005, approximately $6,500 more than they had to pay in January 2002. Clearly, European products are now less attractive to Americans, hurting the European export industry and depressing economic growth.

The dollar has lost more than 20 percent of its value against the Euro since January 2002 and, although it has regained some ground since the beginning of the year, it is expected to fall further.

The dollar-slide has resulted in similar slips in competitiveness in Latin America and Africa, although not without certain benefits. As most Latin American debt is denominated in U.S. currency in loan contracts with foreign banks, governments and corporations in that region can pay down their debt more easily when the dollar is weakening in relation to their own currencies.⁵ In many African economies, the appreciation of local currencies in relation to the dollar brought down import prices and helped to reduce inflation to one-digit or low double-digit numbers.⁶

In Asia, the effects of a falling dollar have been cushioned through policy interventions. Most Asian countries have adopted fixed exchange rate regimes by choosing a certain price at which their central bank is buying and selling U.S. dollars for domestic currency. In order to keep their exports competitive, these countries have bought large amounts of dollar assets on the foreign exchange market, which is preventing their currency from rising against the dollar.

The undervaluation of Asian currencies has led Europeans to complain that they alone have to carry the burden of the dollar's decline.⁷ However, the negative effects of a declining dollar could turn out to be far more devastating for developing countries, particularly those in Asia.

Numerous emerging markets have accumulated large dollar reserves. A recent study by the Center of Economic and Policy Research (CEPR) shows that most developing countries have acquired dollar reserves equivalent to 10 percent of their GDP. The dollar reserves of many Asian economies amount to up to 20 percent of GDP.⁸

In the face of persistent downward pressure on the dollar, it has become increasingly risky for developing economies to keep dollar denominated reserves.

Conventionally the accumulation of international reserves is thought to be beneficial because it allows a country to reassure investors that it could keep its currency stable in times of crisis. However, in the face of persistent downward pressure on the dollar, it has become increasingly risky for developing economies to keep dollar denominated reserves.

First, interest rates on Euro assets are higher than on dollar assets. By investing in dollars instead of Euros developing countries forego higher returns. Second and more importantly, developing countries accumulating dollar assets risk substantial losses of national wealth. With no serious attempt made by the U.S. government to bring its twin deficits under control many experts expect the Dollar to continue its decline. The CEPR study demonstrates that these countries would, on average, lose almost 3 percent of their GDP if the dollar were to depreciate by another 20 percent. This welfare loss could easily outweigh the gains developing countries could expect from complete trade liberalization.⁹

Developing countries, it seems, would be better off if they were to diversify their reserve portfolio buying Euro, English Pound or Japanese Yen instead of dollar assets. Indeed, monetary authorities in China have already stated that the dollar would become less attractive as a reserve currency should the current account imbalances of the U.S. continue to put downward pressure on the dollar.¹⁰

The remarks by Asian and European leaders show that their faith in a strong dollar has been shaken. Only by reducing its budget deficit and encouraging private saving, can the U.S. government avoid a sharp depreciation of the dollar that would have painful consequences for economies all around the globe.

¹Financial Times, Jan 25 2005: France and Germany attack U.S. over Dollars slide.

²Bloomberg, Jan 6 2005: Dollar May Become `Less Popular' as Reserve Currency, Yam Says.

³New York Times, Jan 25 2005: Dollar's Slide Adding to Tensions U.S. faces abroad.

⁴Washington Post, Jan 4 2005: The Long Arm of the Dollar.

⁵Wall Street Journal, Dec 29 2004: Dollar Dragging More Down With It.

⁶United Nations 2005: World Economic Situation and Prospects 2005, p. 93.

⁷Bloomberg, Jan 11 2005: Yen Gains After ECB's Issing Calls Asia `Key' to U.S. Deficits.

⁸Mark Weisbrot, David Rosnick, and Dean Baker 2004: Going Down With the Dollar. The Cost to Developing Countries of a Declining Dollar.

⁹Ibid.

¹⁰Bloomberg, Jan 6 2005: Dollar May Become `Less Popular' as Reserve Currency, Yam Says.




Reprinted with permission from Globalization 101.

To read another Global Envision article about the the declining US dollar, see Why Dollar Hegemony is Unhealthy.



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