The American Eagle Trap: Why a weak dollar won’t save America

Let’s deal with a common misunderstanding, that “dollar devaluation is going to save the US.” The idea supposes that if only the US dollar were low enough, the US would become competitive.

First, take a look at the charts to the left. The US dollar under Bush took a nosedive versus the Euro (and most other currencies as far as that goes). Note that the Yuan appreciates against the Euro, but not the dollar, during that same period.

Why is that? Because China spends a huge chunk of money keeping the Yuan pegged to the dollar. In some years, as much as 10% of their entire GDP.

During the Bush administration we had a massive experiment in devaluation. During the Bush administration ordinary people’s incomes went nowhere, and the era ended in a massive financial crisis.

Before that financial crisis something else interesting happened: there was a huge rise in the price of oil, up to $150 a barrel. (For much of the nineties it had been below $20/barrel.)

At the current time, if the dollar drops, the price of oil will rise.

An increase in the price of oil and other commodities will increases the trade deficit, because commodities need to be imported.

China is the largest source of the US trade deficit: between 2001 and 2009, China accounted for $1.58 trillion of the $3.81 trillion trade deficit (and the percentage increased throughout the period). China will make sure that there is no devaluation of the dollar relative to the Yuan.

Given that the Chinese proportion of the US non oil deficit is 83%, the effect of devaluing the dollar on trade deficits will be essentially zero.

The end effect of dollar devaluation, then, is an increase in the price of oil and other commodities which increases the trade deficit, but has no effect on imports from China.

Given that devaluing the dollar will also lead to an increase in the price of oil, it is entirely likely that it’s net economic effect will be negative, rather than positive, as the US economy shakes apart under exorbitant oil prices. In 2008 the economy shook apart at about $150/barrel. Despite the current lousy economy, the price of oil is now over $70/barrel.

“Right then,” you say. “Let’s force the Chinese to stop spending all that money keeping the Yuan overvalued relative to the dollar! If they won’t, let’s slap countervailing tariffs on them!”

Great idea. Except that China’s need to keep the Yuan overvalued against the dollar is why they buy up US treasuries and other US assets. If they can’t keep the Yuan overvalued against the dollar, and therefore maintain access to the US consumer, then they have no need to inflate the value of US currency. Or to put it another way, what happens if China says “Ok, we’ll stop buying US treasuries and other US assets to keep the Yuan up.”

Question: Who is funding the US government and agency deficit right now?

Answer: China and Japan.

Japan’s new government is very likely to start buying a lot less US debt, because Japan’s trade surplus with the US has been shrinking despite massive currency intervention. That leaves China.

The chart on the left only goes to 2007, since then the US government deficit has rocketed to the highest level in history.

What would happen if China decided to buy a lot less American debt, including US government debt?

US debt servicing costs would climb through the roof, massively increasing the deficit and putting even more pressure on domestic programs.

The US dollar would indeed collapse, and not just against the Yuan. The Chinese ceasing to buy US assets (or even decreasing significantly their purchases) wouldn’t just effect Yuan/dollar rates.

The US trade deficit to China would drop, but it would still not be reversed. (China’s costs are legitimately lower than America’s, although China’s productivity is also lower.)

Inflation would increase significantly. Cheap imported goods have been an engine of deflation for some time now; increasing their price could lead to inflation, especially if there were also a spike in oil prices at the same time. The corollary to increased inflation is a decline in the US standard of living, even if there isn’t an inflation spike (because that would mean a reduction is goods being bought or an economic shock so severe it lead to a deflationary spiral).

If China let the Yuan appreciate to its natural value against the dollar, it would almost certainly throw the US, and the world, into another financial crisis. It would also badly damage China’s economy, which would lead to more riots and instability in China. The advantage to China would be that they could buy oil for much much less than before, and that oil prices for the US would rise (though such a rise might be choked off by a collapse in the world economy). However, any real recovery in the world economy would leave the US with permanently higher oil prices and China with lower oil prices, in itself a competitive disadvantage for the US.

The results, in short, would likely be disastrous. Maybe even catastrophic. On a global scale.

Right now, devaluing the US dollar does nothing for the US. A forced radical devaluation by making China end its peg would probably be disastrous for the US.

The route to prosperity does not run through a dollar devaluation. Or rather it doesn’t run directly through a dollar devaluation. There are things which need to be done first, before the dollar is allowed to float to its natural level.

Radically reduce the US dependence on oil imports. Radically decrease unproductive spending, including military spending and health care spending (by which I don’t mean cutting medicare, I mean taking back the 5% of wasted GDP spent by the private medical industry) . Significantly increase progressive taxes so that the US does not need as much foreign funding.

Since all of those things are third rails in American politics, as we’re seeing now in the health care debate, where a real restructuring of the industry is not even on the table, the US will not escape from the trap it’s in.

In part, the lack of effective and politically viable policy options is because the US political system is broken. (For example, most of the population is in favor of single payer health care, yet this option isn’t even on the table.) In part, it is because America’s citizens want the status quo to continue. After all radically progressive tax increases, cutting the military budget in half or enforcing 55 mile an hour speed limits and putting city cores off limits to most cars aren’t just unpopular with politicians, they’re unpopular with the population as a whole.

America, and Americans, want to live beyond their means. They don’t want to make hard decisions. And the political system doesn’t want to take money away from any powerful interests which benefit from the current system. So the American eagle will remain trapped, dying by inches, because no one is willing to do what it takes to save America from itself.