One More Bubble to Go

The word from Washington and Wall Street is that the worst is over.

Sure, it will take a while for jobs to recover, for housing to come back, and for wages to rise. But we are definitely on the road to recovery from the biggest debt-bubble collapse since 1929.

Maybe. There were actually two debt bubbles. One was driven by Americans borrowing against unsustainable inflation in housing prices. The other was driven by America borrowing against unsustainable inflation in the price of the U.S. dollar. One more bubble is left to pop. When it does, our unique economic cushion -- privileged access to the world's savings -- will deflate. Like overvalued housing prices in the run-up to the 2008 crash, the dollar is headed for a substantial fall. The question is whether our political class can minimize the hit to working Americans' already-battered living standards. On the available evidence, the answer is, "No."

The central threat here is not the currently rising federal deficit, which despite the theatrical hysteria from Republicans and Blue Dog Democrats is a necessary remedy for the collapse of private spending. True, foreigners are financing the fiscal deficit, but because it is stimulating growth, it is ultimately self-liquidating. Rather, the core problem is the accumulating debt that the U.S. economy as a whole owes to the rest of the world, a result of a more chronic condition: 25 years of buying more in the global marketplace than we have been selling -- and borrowing to make up the difference.

Economists debate whether the root cause is that our markets are open or others' are closed, that we spend too much or we produce too little, that we save too little or the Chinese save too much. All contribute in some way, and each year we go further into global hock. In 2006 our "current account" deficit -- the net cash flow to and from the rest of the world -- was 6 percent of gross domestic product, the highest in our entire history. By the end of 2008, the United States owed roughly 30 percent of its GDP to the rest of the world. The current recession has cut spending on imports, which will lower this year's deficit to somewhere between 3 percent and 4 percent of GDP. Still, the red ink will add to our cumulative foreign debt. And with a recovery, the gap between our imports and exports will accelerate.

Ordinarily, when a country continually spends more than it produces, the global supply of its currency grows relative to demand. Sooner or later, the price, relative to other currencies, drops. The prospect of having their future profits returned in cheaper money leads investors to pull out their capital. Hard times follow. As wages drop, so do imports, and lower labor costs increase exports. Eventually, the current account is rebalanced -- albeit at a lower average standard of living.

A rule of thumb in recent years is that the tipping point for a flight of capital is a rising current-account deficit of about 5 percent of a nation's GDP and a rising foreign debt of about 40 percent. But the United States has so far been protected from the consequences of its chronic trade deficit by the unique status of the dollar. Central banks use U.S. dollars as reserves to support their own money supply. Businesses use them to settle international transactions. And the world's rich have considered dollars the safest place to park their savings in a crisis. So the Chinese and other trading partners have been more than willing to lend back the U.S. dollars they earned through their trade surpluses in order to keep American consumers buying their goods -- on credit. Moreover, with some $2 trillion sitting in its banks, the Chinese government can play the international currency markets to keep its yuan undervalued, allowing it to export still more to the United States.

Common sense says that this cannot continue forever. On our current trajectory, the external debt as a share of GDP would roughly double in the next decade. Before we ever reach that point, nervous global investors will be dumping dollars.

When they do, the market's vengeance is likely to be swift and ugly. Interest rates will rise, shrinking investment and slowing growth. In the face of rising unemployment, a plunging dollar will drive up living costs (as all those cheap imports and inputs -- from TV sets and sneakers to oil and automotive parts -- become more expensive). With the U.S.' capacity to borrow constricted, the federal government's countercyclical spending will be constrained. Financiers -- in New York as well as in London, Dubai, and Beijing -- will demand public austerity as the price for their loans. Indeed, investment banker Pete Peterson has already launched a billion-dollar propaganda campaign arguing that the growing U.S. foreign debt requires draconian slashes in Social Security and other domestic programs.

The good news is that Barack Obama, unlike George W. Bush, seems to understand the economic imperative. "We cannot rebuild this economy on the same pile of sand," he has said. We must move "from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad." His advisers, including Larry Summers -- an architect of the collapsed pile of sand -- echo the point.

The bad news is that doing something about it appears too heavy a political lift. We clearly need to organize an international effort to deflate the dollar now, about 20 percent to 30 percent, before it bursts into crisis and falls much more. But the political obstacles are enormous. U.S. corporate investors, who are busy outsourcing and investing overseas, want an expensive dollar so they can buy up foreign assets cheap. Companies that want to produce here and industrial trade unions cannot match their political clout. Not surprisingly, U.S. Treasury secretaries -- from Obama's Tim Geithner back through Bush's Henry Paulson and Clinton's Robert Rubin -- all have insisted on a "strong dollar."

The Chinese aren't anxious to see the dollar reduced against their currency, either. It would cut into their U.S. market. Over time China will have to cut back its dependence on exports and rely more on internal growth. But the Chinese leadership is in no rush to impose economic pain on its own influential exporting industries in order to pull America's financial chestnuts out of the fire. The issue of global rebalance was on everyone's lips when the G-20 leaders met in Pittsburgh this September, but given the internal resistence in the two most important countries, it was on no one's action agenda.

Even so, managing a gradual soft landing for the dollar is not enough. We no longer make many of the goods we buy. To export more, we need to revive our capacity to manufacture and sell tradable goods, which in turn requires shrinking the financial sector back to its basic purpose of providing credit to the country's producers instead of siphoning off capital by issuing overleveraged debt to short-term speculators. But, intimidated by Wall Street, Obama and the Democrat-controlled Congress have not only rescued but reinforced the financial system that brought us to the brink of national ruin. At the same time, serious proposals for public-private efforts to reinvigorate manufacturing are ridiculed by the ideologically constricted Washington policy elite as "protectionism" and -- gasp! -- "industrial policy."

The country needs an economic transformation, and overcoming entrenched opposition in Washington and on Wall Street requires an inspired effort to educate Americans about the reality they face. Instead, the president -- like his recent predecessors -- lectures Americans that they ought to get more education and proposes marginal incentives for businesses to innovate. But American workers do not lack skills; they lack jobs for skilled labor. As for innovation, when our scientists and engineers dream up a new product, it is sent overseas for production.

The reason for this policy disconnect lies deeper than Obama's now obvious deficiencies as a fighter for the causes he eloquently expounds. It is imbedded in a system of governance that for the last three decades has been incapable of dealing with the future because its most important financiers are still profiting from the present.

If facing reality seems too hard, a common human response is denial. So, just as Alan Greenspan assured us that the "self-interest" of banks would prevent overleveraging of bad loans and the dumping of sub-prime mortgage-backed securities in a crisis, today's prevailing view is that the self-interest of China, Japan, the oil sheiks, and other creditors will force them to continue to lend us money as we go deeper into debt. After all, as the saying goes: Owe the bank $10,000 and it's your problem; owe it $10 million and it's the bank's problem.

But the anxious Chinese and other creditors are already diversifying away from dollars. Euros are increasingly used as central bank reserves and to settle oil contracts and other international transactions. Chinese companies are using their dollars to buy long-term claims to energy and other resources in South America and Africa. Brazil, Malaysia, and other nations now accept the Chinese yuan in payment for exports. This past March, the head of China's central bank publicly called for a new international reserve system -- based on a basket of selected national currencies -- to replace the dollar.

In effect, the global smart money is doing two things at once: preparing for dollar deflation and working to delay it in order to squeeze out every last nickel from the deteriorating dollar system. The longer this goes on, the bigger and more potentially destructive the debt bubble grows.

Washington's answer remains "not to worry." The dollar bubble won't burst -- and if it does, we can handle it. After all, didn't we just save the country from a free fall into depression? But smart as they may be, the Bush/Obama teams -- Ben Bernanke and Paulson, Geithner and Summers -- managed to look brilliant because they were able to fund their bailouts by selling overpriced-dollar IOUs to the rest of the world. Next time that won't be so easy.

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