Even if you are not planning an (ever more expensive) European trip any time soon, pay attention to the decline of the dollar. It could portend deeper trouble for the economy.
The dollar just hit a 20-month low against the euro. It now costs $1.32 to buy one euro, and the dollar is falling against other currencies as well.
The greenback is sinking mainly because the United States runs an immense trade deficit with the rest of the world, especially East Asia. Countries like China, Korea, and Japan have an unhealthy co dependency with the United States. Their governments help their industries capture leadership in technologies, products, and jobs. They then sell America far more then they buy. However their central banks happily lend those dollars back to us, so that we can finance the trade deficit and keep buying their exports.
We now owe foreigners more than $1 trillion , about half of it to central banks. Our annual trade deficit is over 7 percent of one year's Gross Domestic Product, and it keeps growing.
If any other country ran such a deficit, foreigners would lose confidence and its currency would crash. That's what happened to Mexico, Argentina, even to Britain in the early 1990s. The United States has avoided that fate thus far, because Asian central banks keep the dollar propped up, and that reassures private investors.
But this game can go on only so long. This past week's decline of the dollar against the euro is rather like the seismic tremors that precede a major earthquake on a fault line. We don't know whether this is the big one. We just know that the big one is coming sooner or later.
No less than former Federal Reserve chairman Paul Volcker put the odds of a dollar crash at 75 percent within five years. He said that more than two years ago.
The dollar fault line keeps widening because of our tricky relations with China. Beijing deliberately keeps its currency undervalued as part of its export strategy, to make its products even cheaper in the United States and to make US exports more expensive in Chinese markets.
This strategy has the desired effect of stimulating China's sales to the United States and enticing US manufacturers to locate production in China to take advantage of the cheap labor, government subsidies, and depressed currency. Treasury Secretary Henry Paulson goes through the motions of pressuring the Chinese to let their currency trade like normal currencies, but Paulson doesn't really want that outcome because a big jump in the value of the Chinese yuan could trigger a run on the dollar.
Paulson has repeatedly said in other contexts that a strong dollar is good for America. He says this, not because a strong dollar helps US exports -- it makes US products more expensive in world markets -- but because he doesn't want investors to flee the dollar and set off a stampede. Paulson's predecessor as treasury secretary in the Clinton administration, Robert Rubin, now a senior executive at Citigroup, confirmed to me in an interview that Wall Street wants only the most modest dollar adjustment.
Due to our dependency on foreign financing of our trade imbalance, which in turn requires confidence in the dollar, we can't behave like normal countries -- let our currency fall, and thereby make our products cheaper in world markets, which would improve the trade imbalance.
And the longer an adjustment is delayed, the more serious the eventual crash. And if the dollar crashed, the Federal Reserve would be torn between raising interest rates to restore foreign confidence in the dollar (and creating a domestic recession) or lowering interest rates to stimulate a domestic recovery (and scaring off even more foreign lending on which we depend).
The alternative to this mess is a more assertive trade policy, so other countries stop playing protectionist games at America's expense. If we exported more and imported less, we would not be so dependent on foreign borrowing to finance the trade deficit. But that strategy is off the table, and in any case would take time to work.
The precarious dollar is also weakened by the big federal budget deficits and the increasing role of hedge funds, which operate like a herd and exaggerate normal swings in currency markets. But Paulson wants even more tax cuts and more financial deregulation.
The dollar dilemma is the Republicans' economic Iraq. It has no easy solution, and could be one more disaster on the watch of George W. Bush.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His column appears regularly in the Globe.
© 2006 The Boston Globe