US dollar: Destination known, road unknown

by Vivek Kaul, DNA
"The US dollar is not strong because people want to hold the dollar, but it's strong because people have debt in dollars."
--George Soros, renowned hedge fund manager
"You know, I have been here for almost a month now and still haven't figured out what I want to do," she said, late on a Sunday afternoon.
"When you don't know where you are going, the journey is the reward," I replied.
"So funny," she replied rather agitatedly.
"OK, let's go out somewhere," I said, grabbing her hand and leading her out of the house.
"What's on your mind? You know, you can be really weird at times," she said as we reached the bus stop.
"We'll take the first bus that comes here, wherever that goes," I said, sounding weirder.
One did five minutes later; a 33 to somewhere. We hopped on and bought two tickets to the last stop.
"Where does this bus go?" she asked.
"I don't know!" I replied.
"Is this some sort of a joke?"
"Like I said, when you don't know where you are going, the journey is the reward. So, enjoy it."
"Oh! I think I'll flip the point you are trying to make. Take the US dollar, for instance. From what we have been discussing, we know it will ultimately crash --- when and how, we don't know. Destination known; road unknown. You know where you are going, but not how and when you will get there. Is the journey still the reward?"
And I thought I had the penchant for linking anything to anything.
"Interesting," I said. "But I think I have some idea of how the US dollar will get there. For 2009, the projected fiscal deficit of the United States is $1.85 trillion. That's four times higher than the maximum deficit the US has previously run. This estimate has been made by the Congressional Budget Office (CBO). It also estimates that the deficit will be $1.4 trillion in 2010. Estimates made also suggest that between 2010 and 2019, the US will run a total deficit of $10 trillion. As you know, fiscal deficit is essentially the difference between what the government earns and what the government spends. And given that it plans to spend more than what it earns, the remaining money needs to be borrowed. Also, like most forecasts, this forecast is also a wee-bit optimistic, I feel."
"As in?"
"See every forecast is made using some assumptions. The CBO has assumed an unemployment rate of 8.8% for 2009. The rate has already touched 8.9% at the end of April. Also, from the way it looks, unemployment in the US is only going to increase in the days to come. Other than this, CBO assumes that the gross domestic product (GDP) growth in 2010 will be 3.8%. Now, given that the GDP contracted by 6.1% in the first quarter of 2009, hoping it will grow at 3.8% the very next year is pretty optimistic. My view is the US fiscal deficit will be more than what it is being projected. And all this money will have to be borrowed."
"Yeah, it will have to be borrowed. But with countries like China and Japan ready to lend to the US, where is the problem?"
"Hold on. In March, China and Japan were net buyers of $48.5 billion of financial securities issued by the US government. These financial securities pay a certain rate of interest and are issued to borrow money. Even Russia bought $8.3 billion of financial securities issued by the US government. Some experts have questioned the credibility of these figures, but assuming you and I trust these figures, there are some serious problems otherwise as well," I said, looking out the window, and realising how little traffic the city had on a Sunday afternoon.
"And what are these problems, if I may ask."
"Estimates suggest the US government needs to borrow $1 trillion by September. It will be very difficult to raise such humongous amount of money given that exports of the major buyers of these securities are falling. Chinese exports are down 41% and Japanese exports are down 38%. These countries earn US dollars through exporting goods and services.
These dollars, in turn, are used to buy securities issued by the US government. When exports fall, dollar earnings also fall. Given that, where will all the dollars to buy these securities come from? Also, we need to remember that the US is not the only country in the world that is running a fiscal deficit. Most of Europe is running a fiscal deficit, and so is Japan. And all these countries need to borrow. One estimate suggests the US, Japan and Europe need to borrow $5 trillion over the next two years. Now, let me be optimistic for a change and assume that there are enough buyers for these securities. But even with that, will the US government manage to find buyers for financial securities amounting to another $5 trillion, which it needs, over the next four years? This, given that the government will continue to spend more than it earns."
"Hmmm... I see even optimism can lead to pessimism. So what is the way out?" she asked as a spurt of wind blew her hair on to my face.
"I guess the only way out is to print money. The Federal Reserve of the US is currently authorised to print $1.75 trillion. This money will be used to buy back financial securities issued by the US government. The theory is that more money in the economy will lead to people spending people more and that in turn will revive the economy. Most western economies are resorting to this in order to get their economies up and running again. Bank of England is planning to buy back bonds worth 75 billion pounds. And the European Central Bank, the central bank of the European Union countries, also recently announced that it would start printing money."
"But wouldn't all this money printing be disastrous?"
"Over a period of time? Yes. But right now, the impact of this has been extremely benign. See, the idea was that increased money in the economy will make people spend more and that in turn will lead to people spending more. But right now, people are tired of spending and not in the mood to spend. That cannot continue forever, and as and when they do start spending again, too much money will chase too few goods and inflation will start showing its ugly head."
"I recently read an interview of Ben Bernanke, where he said, "When the economy begins to recover, that will be the time that we need to unwind those programmes, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.""
"At the cost of repeating myself, economics is not an exact science and I am sure Bernanke also knows that, notwithstanding what he said in that interview. So assume prices start rising in the US and the US government along with the Federal Reserve to start reducing money supply. The simplest way to do it would be to start selling the financial securities they have been buying these days. Once they start doing that, they will be able to suck out money from the market, at least theoretically. But imagine what impact that would have. The biggest buyer of these financial securities would suddenly turn into the biggest seller. Given that, at that point of time, will there be enough buyers of these securities? The prices of these financial securities will crash, as there would be very few buyers at that point of time. Also, as inflation rises, investors who have bought these financial securities would want to sell out."
"Why would they want to sell out?"
"Inflation reduces the value of the money and given that expectation, investors would want to get out and spend that money. All this will lead to the price of these financial securities crashing. And that will also lead to the US dollar crashing because countries like China, Japan and Saudi Arabia own most of these financial securities. Once they have sold off these securities, they would want to convert the dollars they have got selling these securities into their own currencies. A spate of dollar sales is likely to hit the market, and that in turn will lead to the value of the dollar crashing against other currencies."
"And when will this happen? she asked.
"I wish I knew. But as renowned economist Nouriel Roubini, who predicted this crash, recently said, "This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades, America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable," I said.
There was a tap on my shoulder. "Last stop," the conductor said, asking us to get down.
"So where are we?" she asked.
"Goregaon," I said, looking around. "Now that we are here, let us find a coffee shop first."
(The example is hypothetical)