The Battle of the Giants—Who Will Win?

Seemingly unnoticed, a titanic battle is underway between the world’s most powerful economies. U.S. overspending and a calculated gamble to take advantage of a devalued dollar is forcing other nations—the EU included—to pay the tab.

by Melvin Rhodes

It was a major crisis. Our business was closed down for a day by government decree. All employees had to work late to handle the constantly changing situation.

At the time I was working for a major British bank. It was November 1967 and the government then in power had announced on a Saturday night that the British currency, the pound sterling, was to be devalued by approximately 14 percent. Prior to that date, the pound had been valued against the U.S. dollar at $2.80 to the pound; now it would be $2.40. Regular television programs were interrupted in peak time to give this news.

The American dollar as of May 27, 2003, had fallen over 14 percent against the euro this year. Include last year and it has fallen about 45 percent (from 82 U.S. cents to the euro to over $1.18 at the end of May). But in sharp contrast to my experience in 1967, banks are not being closed and you don’t hear about people being asked to do endless hours of overtime. Additionally, little attention has been given to this "news" in the American media.

In stark contrast to Britain in 1967, where only the most reclusive or clueless citizen would not have been aware of the currency’s fall, few in America seem aware at all of the international crisis of confidence in the American currency.

Why the difference?

During the 1960s and into the 1970s Britain staggered from one economic crisis to another. Strikes were rampant, the trade deficit ballooned and the British currency continued to fall. All the former British colonies, except Canada, plus Jordan (one quarter of the world’s nations) used the British currency for their international trade. This trading bloc was known as "the sterling area." Its existence took considerable pressure off the dollar. The two currencies had been the world’s reserve (trading) currencies since the 1946 Bretton Woods agreement that set up the postwar economic order. It was absolutely essential that these two currencies be stable for international trade to bloom.

Some astute economists have noted that Britain’s continual industrial crisis led to a huge trading deficit. The United Kingdom was buying more from other countries than it was selling. Rather than deal directly with the root causes of this, the British government took the option of devaluing the currency against other currencies. This was in order to give Britain a trading advantage, making British goods cheaper and so therefore more attractive to foreign buyers. It would make foreign goods more expensive and result in Britons buying fewer products made overseas.

But the economic problems were caused in part by poor industrial relations and practices that limited productivity, so this strategy didn’t succeed. Eventually, the pound went so low it was barely above the dollar. Today, the exchange rate is approximately $1.65 to the pound. This is an example of how human governments try to find a palatable solution to an economic problem, but the end result worsens the situation considerably.

Why the dollar is falling

The dollar is falling primarily because of the burgeoning U.S. trade deficit, the highest for any nation in human history. At over $40 billion per month, the U.S. currency was suffering from a rising crisis of confidence. Americans have been buying more than 40 billion dollars’ worth of goods each month than they have been selling. That’s a situation that cannot go on.

Imagine if your household was overspending at a rate of $1,000 per month. How long could you continue to do that without any consequences? You might be able to get away with it for a while by adding to your credit card debt load or refinancing, but eventually you would have to face reality. If you failed to, the banks and the credit card companies would help you face up to your obligations.

The United States is in a similar position internationally. Realizing the full extent of the U.S. trade deficit, nations and peoples around the world have been divesting themselves of dollars, fearing a fall in the value of the currency due to a lack of confidence. The more people rid themselves of greenbacks, the more others felt obliged to do the same. Hence, the run on the dollar that seems set to drop its value by over 50 percent against the euro. A leader in the June 26, 2003, issue of The Economist stated: "Several forecasters now suggest that the euro could hit $1.40 by the end of next year."

However, sometime during this steep decline, the U.S. administration decided it wanted the dollar to fall, as Treasury Secretary John Snow gave verbal support to the free fall of the currency. The reason? Classic economic theory is that a devalued currency boosts exports (which are now cheaper) and reduces imports (which are more expensive), thereby reducing the trade deficit. Problem solved?

Well, not really.

Exports may increase and imports decrease, but that will not solve the problem of Americans and the U.S. government living beyond their means. The problem there is a seismic shift in attitudes to money that has taken place in the last four decades, not just in America, but throughout what former French President Charles de Gaulle used to so disparagingly refer to as "the Anglo-Saxon debtor nations," the United States, United Kingdom, Canada, Australia and New Zealand, all of which practiced deficit spending for most of the postwar years.

This has not always been the case. At one time, these were the world’s biggest creditor nations, fulfilling a biblical prophecy in Deuteronomy 28:12: "You shall lend to many nations, but you shall not borrow"—one of God’s blessings for obedience. The British currency was tied to the gold standard (its value was fixed in terms of gold, meaning pounds could be exchanged for gold at that value by anybody) until the time of the Great Depression. America continued to tie its currency to gold right up until 1971 when the Vietnam War and Great Society debts combined to sever the tie. Since then, the United States has effectively been overspending with a currency that isn’t worth what it claims to be worth. There is nothing to back it up—except confidence.
A fall in the value of the currency reflects a lack of confidence, internationally, as large holders of dollars divest themselves of their dollar bills. Interestingly, the decade of the Vietnam War, the Great Society and the social reforms that led Americans to turn their backs on the God-ordained family system, was the decade when America’s debts led to an international crisis of confidence in the United States. Again, this fulfilled God’s prophecy about the consequences of disobedience: "He (the foreigner) shall lend to you, but you shall not lend to him; he shall be the head, and you shall be the tail" (Deuteronomy 28:44), meaning that other nations will eventually be able to have control.

By allowing the value of the dollar to drop by roughly 50 percent, the United States has effectively reduced the assets of foreign investors in the United States and U.S. Treasury bonds by 50 percent. It could be said that America is borrowing (some might say stealing) from other countries in order to continue its profligate ways.

This happened before, in the 1980s. The dollar then was falling against other currencies. The Japanese at that time lost out, big time. They had bought into the U.S. property boom and suddenly found, with the fall in the value of the dollar against the yen, that their American assets were worth far less than they had paid for them. Japan still hasn’t recovered from that incident, which was a contributory factor in Japan’s current problems with deflation (an economy going backwards). This time, the Europeans may suffer the same negative consequences.

Problems in "Euroland"

As the dollar falls, so the euro rises. This will make it harder for European companies to export their goods to the United States, as the price of all such goods in dollars will increase dramatically. With already high unemployment rates throughout the euro zone economies, this will only make matters worse. If the fall in the dollar had altered the exchange rate by 5 percent, the Europeans might have been able to cope—but 50 percent? There will inevitably be some serious consequences.

In fact, it has been speculated that this is a deliberate attempt by Washington to destroy the euro, the dollar’s only viable rival currency on the world stage. The fledgling European currency may not be able to survive the pressure that will result from the greenback’s free fall. Although a rising euro emphasizes the success of the currency, if it rises too high, it could result in the collapse of the economies of member nations. Some have even speculated that this is calculated revenge for Paris and Berlin not supporting the United States over Iraq.

If this is the case, it’s a dangerous game.

There is a very real possibility of competitive devaluations taking place as other countries follow America’s example and let the value of their national currencies fall.

In effect, this would repeat the early 1930s. Following the stock market crash of October 1929, the United States passed the Smoot-Hawley Act, which imposed high tariffs on imported goods. Other nations followed suit and a worldwide slump, the Great Depression, was the result. Competitive devaluations in the value of currencies would have the same result but would get around World Trade Organization rules on tariffs and trade.

An early indicator of developments moving in this direction was the decision of the European Central Bank to lower its key interest rate June 5, thereby reducing the appeal of the euro. The measure did slow the rise in the value of the European currency, but it has not stopped the trend of money moving away from the dollar into the euro.

The U.S. Federal Reserve followed suit 20 days later and reduced its interest rate, thereby making the dollar even less attractive. Having regained a little of the ground lost to the euro during the intervening three weeks, many speculate that the greenback still has further to go down against the European currency.

Not only are Europeans losing out as a result of the dollar’s fall, so are others. The American assets held by foreign companies have lost about half of their value in the last 18 months, a loss that will reflect badly in this year’s balance sheets. All nations that do significant trade with the United States are likely to see a dramatic fall in sales this year. Additionally, nations that export oil, minerals and raw materials, most of which are priced internationally in dollars, will find that they are going to be earning less, but will in turn have to pay higher prices for goods bought from the countries of the EU.

It has already been suggested by some Arab oil ministers that oil be priced in euros. The pressure for this must increase as oil-producing nations see the value of their oil dropping with the dollar. If (perhaps "when" would be a more accurate term here) oil producers opt to fix the price of oil in euros, the U.S. economy would be in deep trouble. The trade deficit would have to be reduced to zero overnight and America would have to increase its sales to the EU just to keep up its oil consuming habits.

Which brings us back to the root cause of the problem: overspending in the United States. Overspending is occurring at every level, among consumers, corporations and government—both federal and state governments.

Even the recent tax cuts will only worsen this situation. Without an equal cut in spending, the result will be a bigger federal deficit and a bigger trade deficit as consumers use some of the extra cash to buy foreign goods.

Added to this is the simple fact that all this borrowed money has to be paid for eventually. When will that happen? The sad reality is that the children of today’s generation will have to pay off the bills. Unlike previous generations, this generation will leave its children massive debts, instead of an inheritance.

Americans have chosen short-term gain over long-term interests. Rather than tighten belts now, the country has chosen to feed its credit binge with yet more spending with the inevitable result that our children and their children will be much worse off than we have been. —WNP

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