Why We Will Dodge a Dollar Disaster
By Jim Jubak
MSN Money Markets Editor
3/23/2005 7:14 AM EST
First the bad news: The U.S. trade deficit hit a record $666 billion in 2004, and the euro is up 47% against the dollar since May 2002. The dollar's decline means slower economic growth, higher interest rates, a stagnant stock market and a slippage in the U.S. standard of living. All of which is enough to make me a pessimist.
Now the good news: The dollar isn't going to crash, and those market pundits urging you to short everything except gold and silver are wrong.
I don't buy the extreme scenarios because they underestimate the feedback mechanisms in capitalist economies that kick in when a trend swings too far in one direction or the other. In the current case, these mechanisms will help limit the damage to the dollar -- and to the U.S. and global economies.
Let's do a comparison of the dollar and its main global competitors, the euro and the yen, on the crucial points.
If you prefer euros to dollars, though, what's important to you is the projected trend in future deficits. According to the OECD, the budget deficit will drop to 2.9% of GDP in France in 2006 and to 2.2% in Germany. But it will stay almost steady at 4.2% in the U.S. Score a point for the euro -- but definitely score one or more against the yen. Japan ran a government budget deficit of 6.5% of GDP in 2004, and the OECD is projecting the deficit will drop just a smidge to 6.3% in 2006.
Again using OECD projections, the U.S. economy will grow by 3.3% in 2005 and 3.6% in 2006 (in real terms, that is, after subtracting inflation). France's economy will grow by just 2% in 2005 and 2.3% in 2006. Germany will struggle with even slower growth of 1.4% in 2005 and 2.3% in 2006. For the euro-zone as a whole, growth will come in at 1.9% in 2005 and 2.5% in 2006. Japan, the home of the yen, is projected to show economic growth of just 2.1% in 2005 and 2.3% in 2006.
Well, then, think how much worse the financial squeeze is in countries where the population is aging more quickly than it is here. In the euro-zone countries right now, there are 35 people of retirement age to every 100 of working age, according to the U.N. (In the U.S., the ratio is about 15 to 100, by my calculations.)
By 2050, the ratio in euro-land will be 75 people of pension age to every 100 workers, and in countries such as Italy and Spain, the ratio will be close to 1 to 1. German workers already pay almost 30% of their wages into the state pension plan. In Europe those demographics will, I think, make the OECD forecasts of falling budget deficits wildly optimistic, because they're founded on the assumption that European governments will be able to get the huge pension liabilities for their huge force of government workers under control.
In Japan, where the population is aging even faster, the budget problem is even worse. Fully one-third of Japan's population will be 60 years or older within a decade, according to Phillip Longman's book The Empty Cradle.
To me, this situation puts a limit on how far the dollar will fall against the euro and the yen, the two other major international trading and investing currencies. The current decline of the dollar against those currencies comes as foreign central banks decide to diversify their holdings of foreign exchange. For a central bank like the Bank of Korea, for example, that means reducing the current 60% to 65% of the bank's $210 billion in foreign-exchange reserves now in dollars by adding investments in euros, yen and a few other currencies. Globally, the U.S. dollar made up 64% of central bank reserves at the end of 2003.
If foreign central banks stopped buying dollars entirely, according to Wall Street estimates the dollar would have to drop another 30% and U.S. bond yields would have to climb by 4.5 percentage points to attract enough private capital to fill the gap.
That's a worst-case scenario, and you'll note that it's still well short of the end of the world. And because you can't just sell a dollar without buying some other currency, the weaknesses in the yen and euro economies mean that the move away from dollars will stop well short of that. For example, even today, the yen makes up only 5% of central-bank reserves, because Japanese government bonds yield almost nothing and because the attractiveness of the yen is dampened, shall we say, for anyone who understands Japan's impending budget meltdown.
The same with the euro; euro-denominated bonds yield less than U.S. Treasuries, making diversification out of dollars and into euros prudent in the long run but painful in the short run. Closing that dollar/euro yield gap doesn't seem to be in the cards, either, because raising interest rates in Europe would slow those slow-growing economies even more.
And as my comparison of the economies and budgets of the dollar, euro and yen economies should tell you, the U.S., thanks to its faster economic growth rate, has more room to raise interest rates -- without producing a recession -- than the economies of its currency competitors.
So, yes, the U.S. dollar is headed lower, U.S. interest rates are headed higher, and U.S. economic growth won't be as fast as now projected, but all this decline will stop well short of the dollar disaster that might produce a domestic or global financial meltdown ... all because the economies of Europe and Japan are in even worse shape than ours is.
Now, doesn't that make you feel better?