To understand the source of the problem, as well as its solution, we can start with the so-called strong dollar policy of the 1990s. Robert Rubin's words did not make the dollar strong, the Clinton administration's economic policies did. Five years ago, the stock market was booming and the federal government budget was in surplus. Then, the current account deficit could be explained as reflecting the capital flowing into the US because foreigners saw it as a good place to invest.
In 1999, reducing the current account deficit would have meant making the US a bad place to invest. Over the past five years, that may have happened. Foreign demand for American assets has waned even as the current account deficit has grown. What is surprising is not that the dollar has fallen, but that interest rates have not increased. These tend to go hand in hand.
The mystery can be solved by looking at the behaviour of central banks, especially in Asia. According to the Bank for International Settlements, in 2003 the world's central banks increased dollar reserves by $441bn, or 83 per cent of the US current account deficit. Since euro-area central banks were net sellers of dollar reserves, it is clear that the Japanese and Chinese were buying US treasury bonds.
Maybe it is just a coincidence, but the foreign increase in dollar reserves roughly matches the federal government's budget deficit. To put this bluntly, the Japanese and Chinese financed the Bush administration's deficit in 2003. (Maybe this is their contribution to the nearly $2bn weekly cost of the Iraqi occupation.)
It is worth reflecting on why these Asian governments did this and what the consequences are likely to be. In most countries, foreign exchange reserves are not primarily on the books of the central bank. Instead, they belong to the fiscal authority or even some entirely separate entity. Importantly, these entities publish their balance sheets regularly and are normally required to show the market value of their assets. This means that if they were to become technically insolvent, we would know it.
We can start to see why governments with large dollar reserves would be concerned about both keeping the dollar from depreciating and ensuring that US treasury bond interest rates do not go up. Both of these would result in capital losses for the entities holding the foreign exchange reserves. Given that these reserves are huge - more than $800bn in Japan and more than $500bn in China - the potential losses are big, as is the potential embarrassment. A 10 per cent appreciation of the renminbi means a capital loss of $50bn for Chinese authorities. Assuming the duration of their bond portfolio is three to five years, a 2 percentage point increase in US interest rates means another loss of $30bn-$50bn.
It is hard to see a way for the Asians to get out of this bind without American help. Statements by the treasury secretary will not do the trick. Foreign exchange intervention will be equally ineffective unless it signals that something fundamental has changed.
For traders to stop hammering the dollar, the Bush administration has to provide a credible signal that fiscal policy is going to change very soon. So far, they have only made things worse. The president has said he wants to make his first term tax increases permanent, provide some further tax cuts for individuals and corporations, and reform social security. Together these measures look likely to raise treasury debt by another $3,000bn or so. Where is this going to come from?
There is a limit to foreigners' willingness to finance American consumption, and the fall in the dollar is the first sign we are reaching it. As difficult as it is for the president to admit, the solution is a tax increase. This will decrease domestic consumption, reducing the current account deficit, reduce the issuance of treasuries, and make the US a good place for long-term investment the way it was in the 1990s. Only then will the dollar stabilise and the risk of a dramatic interest rate increase be reduced.
Americans are usually the first to extol the virtues of capital markets in disciplining policymakers who implement unsustainable fiscal policies. We know from watching the emerging world that when fiscal deficits and current account deficits grow too large, hot money flees a country, driving its currency down and interest rates up.
If the US government does not do something soon, it will experience the fate of Latin American countries and suffer a financial meltdown. Dollar depreciation is just the beginning. The foreign exchange traders are doing reconnaissance for the bond vigilantes. If nothing changes, watch out.
Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.