Deficits, the Dollar, and IEDs

The world's richest man, joining the world's second richest man, is now betting against the dollar:

Bill Gates, whose net worth of $46.6 billion makes him the world's richest person, is betting against the U.S. dollar.

"I'm short the dollar," Gates, chairman of Microsoft Corp., told Charlie Rose in an interview late yesterday at the World Economic Forum in Davos, Switzerland. "The ol' dollar, it's gonna go down."

Gates's concern that widening U.S. budget and trade deficits are undermining the dollar was echoed in Davos by policymakers including European Central Bank President Jean-Claude Trichet and German Chancellor Gerhard Schroeder.

The dollar fell 21 percent against a basket of six major currencies from the start of 2002 to the end of last year. The trade deficit swelled to a record $609.3 billion last year and total U.S. government debt rose 8.7 percent to $7.62 trillion in the past 12 months.

"It is a bit scary," Gates said. "We're in uncharted territory when the world's reserve currency has so much outstanding debt."

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Gates reflected the views of his friend Warren Buffett, the billionaire investor who has bet against the dollar since 2002. Buffett said last week that the U.S. trade gap will probably further weaken the currency.

"Unless we have a major change in trade policies, I don't see how the dollar avoids going down," Buffett said in an interview with CNBC on Jan. 19.

Gates in December joined the board of Berkshire Hathaway Inc., the investment company that Buffett runs. Forbes magazine's list of billionaires ranks Gates, 49, No. 1. Buffett, 74, is second, with more than $30 billion. Almost all of it is in Berkshire stock. (emphasis added, James Hertling and Simon Clark, "Bill Gates, World's Richest Man, Bets Against Dollar (Update3)," Bloomberg.com, January 29, 2005)

Will the dollar be one day the target of speculative attacks by hedge funds, as in the last days of the overvalued pound sterling?

In 1992, the ERM [Exchange Rate Mechanism, "a fixed-exchange-rate regime established by the then European Community designed to keep the member countries' exchange rates within specific bands in relation to one another"] was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Wednesday, September 16, a culmination of factors led Britain to pull out of the ERM and to let the pound float according to market forces. Black Wednesday became the day on which George Soros, hedge-fund titan, broke the Bank of England, pocketing US$1 billion of profit in one day and more than $2 billion eventually. The British pound was forced to leave the ERM after the Bank of England spent $40 billion in an unsuccessful effort to defend the currency's fixed value against speculative attack. (Henry C K Liu, "Banking Bunkum: Part 2: The European Experience," Asia Times, November 8, 2002)

Recently, the dollar rallied a bit after data "showed investments coming into the United States were more than enough to cover the country's huge trade deficit on a monthly basis," but they may mainly consist of hot money:

Net flows of capital into U.S. assets surged to $81 billion in November from a revised $48.3 billion in October and were far above market expectations of around $55 billion.

November's inflows more than adequately covered the trade deficit of around $60.3 billion for the month.

Following the U.S. data, some analysts have started cautiously entertaining thoughts that the dollar's rally in the past few sessions could be more than just a fluke.

"There's a chance the euro has seen its high for the cycle and Asian currencies have further to adjust," said Bob Sinche, head of global currency strategy at Bank of America in New York.

The U.S. flows data "continue to show that U.S. assets have appeal and that the scare stories about the twin (budget and trade) deficits aren't really valid," he added.

Michael Woolfolk, senior currency strategist at Bank of New York, reckoned however that much of November's asset inflow was speculative, given an increase in investments from Caribbean money center banks.

These banks are known to be financing channels for most hedge funds, which have become major players in the daily $1.3 trillion turnover of the global foreign exchange market. (Gertrude Chavez/Reuters, "Dollar Rises on Investment Flows Report," January 18, 2005)

Short-term fluctuations aside, the dollar has nowhere to go but down, and the only question is whether the fall will be gradual or sudden and precipitous:

Provided the dollar's fall is gradual, it should prove manageable for the world economy. But that doesn't mean there won't be some dislocations. The higher inflation and interest rates brought on by the weaker dollar will mean that U.S. consumers will have less money in their pockets to spend. And U.S. companies will find it harder to make acquisitions overseas. "Many of us will feel a little bit poorer," says Kenneth S. Rogoff, former International Monetary Fund chief economist and now a professor at Harvard University. But Japan and Europe could be hit harder unless they take action to boost domestic demand to offset the loss of their exports.

Of course all bets would be off if the dollar suddenly nose-dived, dragging U.S. stock and bond prices down with it. That would raise the risk of a global recession. (Rich Miller, "Why The Dollar Is Giving Way," BusinessWeek, December 6, 2004)

See, also, Brian Bremner, "The Makings of a Meltdown" (BusinessWeek, December 13, 2004).

The US power elite are hoping that it is possible to engineer gradual devaluation of the dollar and stimulate US export, shrinking the US trade deficit, but it turns out that "the US does not have adequate manufacturing capacity to eliminate the external deficit":

There is now a consensus in the financial markets that the US dollar is headed for a prolonged slump in order to reduce America's large current account deficit.

There are two ways the falling dollar can reduce the external deficit. It can encourage an upsurge of exports or import substitution. What pundits have not noticed is that the US does not have adequate manufacturing capacity to eliminate the external deficit.

The US economy produces about Dollars 1,500bn per annum of output in its manufacturing industry and has a capacity utilisation rate of nearly 79 per cent. The current account deficit is equal to 40 per cent of American manufacturing output. If the US were to reduce the external deficit by Dollars 150bn through an improvement in the merchandise trade account for goods, the manufacturing capacity utilisation rate would increase by 7 per cent to 86 per cent. If the US were to seek to eliminate the deficit entirely through a boom in exports or massive import substitution, the utilisation rate would exceed 100 per cent.

As the Federal Reserve regards a rate above 85 per cent as inflationary, there is little doubt that it would tighten monetary policy if changes in the trade account were to produce such a big swing in the utilisation rate. In this scenario, the US might ultimately reduce the deficit through a domestic recession, not an export boom.

The US has inadequate capacity to control the external deficit because its manufacturing capital stock has been declining in relative terms for several years. In 2003, this stock was equal to 7.3 per cent of total fixed assets, compared with 8.4 per cent in 1985. The share of US private employment in manufacturing has also shrunk from 22.4 per cent in early 1985 to 13 per cent recently. The recovery in capital spending after the 2001 recession was the most subdued in modern business cycle history. Between mid-2002 and 2003, capital spending increased by only 5 per cent compared with an average gain of 15 per cent during the first year of the five previous business expansions. . . . .

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The decline of the dollar is only the first step in the process of adjusting America's balance of payments. There will also have to be a significant reallocation of resources from domestic consumption to tradeable goods manufacturing. The great question is whether the US will be able to reduce the deficit through a gradual manufacturing revival or, dramatically, through a domestic spending recession. (David Hale, "Don't Rely on the Dollar to Reduce the Deficit," Financial Times, USA Edition, January 26, 2005, p. 15)

A "significant reallocation of resources from domestic consumption"? Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, puts it more plainly: "No matter what the outcome, Americans will have to consume a lot less" (emphasis added, qtd. in Dan Ackman, "Doom for The Dollar -- and Everything Else," Forbes, January 10, 2005).

The US power elite will demand that the US working class reduce consumption -- gradually or dramatically -- to haul the multinational ruling class out of the abyss of the US current-account deficit, at the same time as forcing the US working class to make greater and greater sacrifices as IED fodders, sinking further into the quagmire in Iraq. Can American workers fight back, recognizing who their true enemies are (rather than taking it all out on Iraqi prisoners or worrying about how to prevent gay men from having abortions)?