John Rapley, Contributor
FINANCIAL ANALYSTS have been transfixed by events on world currency markets. The American dollar, for so long the planet's reserve currency, suddenly seems to be out of fashion. Next to a basket of major currencies, its value has been falling sharply.
It may well be that this is a boomerang effect of the Asian Crisis. Back in 1997-98, when Asian currencies began plunging, creating a contagion that spread around the world, investors across the planet rushed to the safe haven of U.S. Treasury securities. Hundreds of billions of dollars flowed into U.S. accounts.
BIG BOOM
Demand for U.S. securities drove up the dollar's value. A stronger dollar led to lower import prices, which restrained inflation.
At the same time, all those dollars had to be parked somewhere. They quickly found their way onto the U.S. bond and stock markets. Demand for bonds drove up their prices. Given the way bond markets operate, that drove down yields, which reduced interest rates across the board.
Meanwhile, the stock market, into which many ordinary Americans had bought earlier in the decade, soared. It was a great time in the US inflation was falling, credit was cheap, and personal wealth swelled.
This happy confluence of events produced the biggest boom in U.S. history, one Americans will remember with fondness for years.
But as Americans went on the spending-spree of their lives, their country's trade deficit soared and their savings disappeared. For as long as foreigners wanted to keep their money stored in the U.S., America could pay for its imports by, in effect, printing money. But sooner or later, as the deficit reached record levels, a breaking-point would come.
Some say the U.S economy can continue running a deficit for years with no serious consequences. Others suggest that we may now have crossed into the danger-zone.
As foreign inves-tors and foreign central banks lose their appetite for U.S. reserves, pressure on the dollar has risen. A self-reinforcing effect could come into play. If foreigners fear the dollar will decline in value, they will withdraw their funds so as to prevent any losses. As they withdraw their funds, the value of the dollar will go down.
The best-case scenario is that the value of the dollar will continue declining at a measured pace. Ultimately, this will slow but not halt the U.S. economy. And in the short-term, things could actually improve in the US a lower dollar will cheapen U.S. exports, encouraging a boom in U.S. manufacturing.
Those who hold to this scenario maintain that the vast financial reserves of the U.S. make an Asian-style crisis unlikely: whatever people are selling, someone will always be willing to buy. There will thus be no run on the dollar. Needless to say, those who hold to the worst-case scenario do not share this confidence. As the dollar falls, import and commodity prices will rise, putting upward pressure on inflation.
As inflation rises, so, too, will interest rates, accelerating the rise in bond yields required to attract funds back into the U.S. As interest rates rise, the stock market will fall, and credit-fed consumption will dwindle. A global crash, similar to that of 1997-98, is not out of the question.
ASIAN CRISIS TWO
Most likely, the eventual outcome will fall somewhere between these two extremes. But much will hinge on the decisions of foreign central bankers, and especially the Chinese central bank. Asian central banks, eager to preserve the export-competitiveness of their economies, have been buying U.S. treasury paper by the planeload in order to keep the dollar strong.
They may continue doing so. Japan and China have the financial resources to keep it up for a while. But, if other central banks start to jump ship, the Chinese may decide to cut and run. In that case, a plunge in the dollar would become possible. In the end, much will depend on the fundamentals of the U.S. economy. If productivity remains high and labour costs remain low, it will still be an attractive place to invest. A falling dollar will thus eventually pull investors back in.
But if things change on those fronts, a falling dollar could prompt a rush for the exits. Then it would become the Asian Crisis, Act Two.
John Rapley is a senior lecturer in the Department of Government, UWI, Mona.
