Deficits and Dollar Strength

Senator Judd Gregg recently stated that the United States is on the fast track to a “banana-republic type of financial situation” due to the monumental borrowing of late.  Rightly, many are concerned about growing deficit spending and the devaluing of the dollar.  Yesterday Bob McTeer wrote a very good piece on how the dollar, deficits, and China’s holding of U.S. debt are all interconnected.  Here’s a bit of that article:

China has absorbed fewer dollars lately because our trade deficit has shrunk as reduced domestic demand has reduced our demand for imports more than reduced foreign demand has reduced the demand for our exports. China’s dollar holdings are influenced by everything that affects our trade deficit and capital inflow, including our budget deficit, along with personal and business saving.  Those holdings aren’t independent of these complex relationships.

If any category of our national saving increased, other things equal, our current account deficit would tend to shrink. An appreciating dollar would likely be part of that adjustment process. So, more personal saving, more business saving, or more government saving (a smaller deficit) would all tend to strengthen the dollar. Conversely, a reduction in those categories by our trading partners would have a similar effect.

One caution: if the government increases its deficit to increase transfer payments, which get saved by the recipients, there is no increase in national saving. The greater government dissaving offsets the greater personal saving.

Personally, I like to use the term stable when referring to the dollar.  Unfortunately, it’s been anything but stable over the last few months as the euro and most other major currencies have been rising in value versus the dollar.  Trying to artificially support or devalue the dollar is only a quick fix for one ailment or the other.  Yes, a weaker dollar makes our exports relatively cheaper for our trading partners.  However, much of what we buy as Americans – whether it’s business, personal, or government spending – costs more due to the weak dollar.  Obviously, if the dollar is extremely strong, it’s more difficult for U.S. businesses to sell goods overseas.

Okay, let’s cut to the chase.  Some say, and I would tend to agree, that a strong (maybe healthy is a more appropriate adjective) dollar is nothing more than a symbol of the country’s underlying economic strength.  It makes sense that foreign investors would rather invest in a country with a relatively low debt burden anchored by a growing economy than one that’s stagnant and debt-ridden.

Jimmy Pethokoukis spells out the potential trouble which could result from irresponsible government spending:

Indeed, the evidence points to a nation fairly far along that path. Healthcare reform is supposed to be deficit neutral — everything paid for via spending cuts or tax increases — while also helping bring government’s overall long-term budget into balance.

But to keep the 10-year price tag under $900 billion, Democrats have quietly shunted $247 billion in spending for Medicare physician payments into a separate bill. And no effort is being made to pay for it.

Just as egregious, though less expensive, is the Obama administration’s $14 billion plan to send a $250 “stimulus” check to 57 million American Social Security recipients in lieu of an annual cost-of-living increase.

Two examples — one ridiculously expensive, one just ridiculous. But both reveal a nation completely unwilling to deal with current trillion-dollar deficits or long-term shortfalls many multiples of that number.

What confidence should dollar investors have that America will really cut entitlement spending? Very little. Instead, we are more likely to see huge tax increases that could cripple productivity, or further dollar neglect, or a central bank that turns dovish on inflation. Or perhaps all three.

The virtues of expansive government is vastly overrated.  Generally, private firms – the efficient ones who understand that debt is no gift – get crowded out and taxed to death.  Contrary to the cries of some, capitalism did not lead us astray.  Behind every good economic debacle are numerous government initiatives once sold as plans to help the citizenry.  Translated:  ploys to garner votes.  The truth is that capitalism is our only way back to long-term economic health.  Piling debt on top of debt is simply a recipe for disaster.

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