Friday, October 26, 2007

The U.S. dollar index, which measures the greenback's strength against other major currencies, recently hit its weakest level since 1973. However, many experts (as well as the International Monetary Fund) believe the buck hasn't even hit rock bottom — and project a further major decline based on chronic U.S. trade imbalances. To understand the three major forces driving this chronic trade deficit is to understand what must be done to restore confidence in America's currency.

First, America's chronic trade deficit may be directly traced to its lack of fiscal responsibility and monetary restraint. The U.S. has run chronic budget deficits throughout the Bush administration which have over-stimulated consumer demand for foreign imports. A primary culprit here is the volatile combination of simultaneously cutting taxes and fighting a very expensive war.

At the same time, the U.S. Federal Reserve has engaged in an ultra-easy monetary policy since the 9/11 terrorist attacks. This has likewise over-stimulated demand for foreign imports — principally, by turning the American home into an ATM.

Second, even as U.S. oil consumption has only barely inched up, our oil import bill has skyrocketed. The culprit here is persistently high oil prices. Now, as OPEC's kings and princes sit uneasily on a growing mountain of dollars, some are beginning to quietly dump dollars in foreign currency markets, creating, in effect, a speculative OPEC dollar downdraft.

Third, there is the burgeoning U.S.-China trade imbalance — more than $250 billion a year and counting. While cheap labor provides China with an important edge in world's export markets, much of China's competitive advantage may be traced to a set of unfair trading practices that range from illegal export subsidies and rampant counterfeiting and piracy to lax environmental and health and safety regulations. However, the most distorting of China's unfair trading practices is its flagrant currency manipulation.

China manipulates its currency by pegging its value to the U.S. dollar. It maintains this peg by recycling the dollars U.S. consumers spend on cheap Chinese goods back into the U.S. bond market. China's currency manipulation, in turn, forces other countries like Japan, Malaysia, Singapore, South Korea and Taiwan to manipulate their own currencies for fear of losing market share to an emergent China.

It is precisely this U.S. dollar-Chinese yuan peg and its collateral effects on other Asian currencies that is forcing the Euro to bear the brunt of the dollar's decline. Even as the European economy continues to downshift, the Euro keeps ratcheting upward. The resultant reduction in European export competitiveness virtually guarantees slow growth — and a possible recession — in Europe.

Now that we understand why the dollar is in its freefall and how it can harm Europe, it is useful to ask whether a falling dollar is good or bad for America? The falling dollar is good because U.S. industries sell more of their exports and U.S. consumers buy fewer foreign imports. This means more jobs for Americaand a reduction in the U.S. trade deficit — just as a flexible currency is supposed to do.

The falling dollar is bad, however, because U.S. consumers must pay more for foreign imports. This makes a falling dollar inflationary. This inflation, in turn, helps drive up interest rates and mortgage rates. By reducing consumption and caU.S.ing inflation and higher interest rates, a weak dollar can, in turn, induce a recession.

As for the worst-case scenario, a falling dollar has the real potential to trigger a stock market collapse. If enough investors believe that the dollar is indeed going to drop by another 15 percent to 20 percent or more and suddenly cash out of the U.S. stock market to invest elsewhere, a crash — followed by a severe recession — becomes a foregone conclusion.

To dodge this declining dollar bullet, it is critical that the U.S. government began to practice both fiscal and monetary discipline. This means balancing our budget and engaging in a neutral, rather than an easy money policy.

It is equally critical that the U.S. crack down on China's unfair trading practices. This is particularly true of China's currency manipulation which is grossly distorting currency values around the world and particularly punishing the euro.

The bottom line is that for America to be strong, its currency cannot be weak.

Navarro is a business professor at the University of California-Irvine and author of 'The Coming China Wars.' Visit www.peternavarro.com