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The Dollar Is In Trouble

By Peter Bernstein

November 2004


The dollar is in trouble, but it has been in trouble before. Perhaps the past holds the solution everyone seeks.

On September 22 1985, the ministers of finance and governors of the central banks of France, Germany, Japan, the UK and the US signed an accord at the Plaza Hotel in New York City. It stated that signatories "were of the view that recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been reflected fully in exchange markets...In view of the present and prospective changes in the fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to co-operate more closely to encourage this when to do so would be helpful."

Over the next two years, the dollar dropped by 30 per cent and America's deficit on current account began shrinking. By 1991, the current account was just about in balance. A neat job, elegantly executed.

Could we replay the Plaza Accord today? The case would be difficult to make. Aside from enormous differences in the magnitude of the economic problem, the political setting bears no resemblance to 1985. At that time, the ministers and governors who gathered at the Plaza were old pals, used to finding solutions to common problems. The western powers and Japan dominated the world, and everybody else genuflected before them. Today, the picture is far more complex.

On the economic side, the scale of the problem is daunting. The rapidly expanding US current account deficit is now more than 5 per cent of gross domestic product, as against only 2 per cent in 1985. Furthermore, the small surplus of 1991 was also the consequence of a recession in the US that curtailed the flow of imports even as exports kept rising - but the US slipped right back into the red as soon as recovery got under way. Helped by a 25 per cent appreciation in the dollar between 1991 and 2001, the current account deficit has been climbing ever since. In 1985, foreign official assets in the US were a fraction of what they are today; since the end of 2002, growth in official holdings has amounted to more than $450bn. In 1986, the price of oil dropped by 50 per cent; today, the concerns are just the opposite.

In many parts of the world, economic growth is excessively dependent on exports, which depend on a strong dollar. On the US side, the authorities welcome the willingness of exporting nations to finance America's appetite for imports, as it helps finance the federal government's bulging deficit.

But, as Herb Stein, the late economist, put it: "If something can't go on forever, it won't." Private capital inflows into the US are already shrinking. There is a point at which one or central bank or other will cry "Enough already!" and the house of cards will fall in. Indeed, China has already begun diversifying its foreign exchange reserves into other currencies and investments. Protectionist pressures are developing within the US, which - to borrow the Plaza Accord's words - "if not resisted, could lead to mutually destructive retaliation with serious damage to the world economy". At the same time, Americans are creating a setup for foreign nations to blackmail them over unpopular US policies by threatening to cease accumulating dollars, thus prompting the dreaded crisis.

There is, however, a vested interest around the world that firmly opposes "some further orderly appreciation of the main non-dollar currencies against the dollar". Many countries are hooked on exports rather than domestic demand as the engine of growth. Accumulating US government securities in such copious amounts is not exactly comfortable, but appreciation of their currencies against the dollar would be even more uncomfortable, as it would deprive them of their main economic stimulant. The important exception is China, which appears to be laying the groundwork for an eventual appreciation of the renminbi against the dollar.

Nevertheless, as Stein reminds us, the current situation cannot go on forever. The worst solution would be to yield to protectionist pressures in the US, which would immediately invite retaliation abroad. The optimal solution is a replay of the Plaza Accord - an orderly appreciation of the main non-dollar currencies against the dollar, which is a more generalised method of curtailing America's appetite for imports while spurring the development of domestic sources of growth in the rest of the world. Without such an accord, the outlook for an orderly dollar devaluation is dim.

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