Climbing debt casts doubt on dollar's future

Job No. 1 for new Treasury chief: Avoid a 'hard landing.'

The buck starts here: As Henry Paulson gets ready to take the helm as US Treasury secretary, a single dollar is worth about 116 Japanese yen, 8 Chinese yuan, and 0.79 European euros. Amid predictions that its value could decline by 25 percent or more, where the US currency goes from here will be a major concern of his tenure.

The issue will help shape the direction of US interest rates, the price of goods in stores, and the health of the world economy.

Many economists believe the dollar will decline in value – and needs to decline – rela- tive to other currencies. The reason: The record US trade deficit shows no signs of shrinking on its own accord. The larger it grows, the greater the risk of a "hard landing" for America if other nations become worried about America's ability to repay foreign creditors, who are now lending some $1.6 million per minute to finance overall US spending.

The hard landing scenario, which could spark a global recession, remains a possibility rather than a consensus forecast. But policymakers worldwide, from finance ministers to the International Monetary Fund (IMF), take the threat seriously.

"The thing that's driving the international focus is the concern that the adjustment [in the dollar] could easily be disorderly and really painful," says Charles McMillion, president of MBG Information Services, an economic consulting firm in Washington. "This imbalance will dominate Paulson's and [Federal Reserve Chairman Ben] Bernanke's efforts, for the rest of their terms."

Mr. Paulson, who was confirmed by the Senate last week, is expected to be sworn in any day to a job that includes being official spokesman on the dollar's value.

He comes to the post from the same investment bank – Goldman Sachs – as Robert Rubin, the Treasury secretary known for a "strong dollar" policy during the Clinton presidency.

What's changed is the global economic environment. America's so-called current account – a broad measure of trade and money flows – is running a deficit in the neighborhood of $800 billion annually, four times as big as in 1995, when measured as a share of the US economy.

"We now have record indebtedness with the rest of the world," says Paul Kasriel, an economist at the Northern Trust Corp. in Chicago. "People have to have confidence that you're going to be able to pay them back."

So far, that confidence remains intact, with the dollar as the dominant reserve currency for central banks. It's also simple necessity: Many nations rely heavily on exports to the US.

Many economists see the magnitude of such imbalanced trade as unsustainable in the long run.

In the hard-landing scenario, foreign governments and investors might conclude that so much lending to the US is unwise. They may seek better returns elsewhere, or worry that the US government won't be able to meet its long-term obligations without resorting to an inflationary use of government printing presses.

The result could be a sharp drop in the dollar, an upward spike in the cost of borrowing in the US, and trouble for countries dependent on US trade. That's a recipe for recession.

Yet economists are divided over the best path forward. Some call for a gradual decline in the dollar, managed carefully by the rhetoric and actions of finance ministers and central bankers.

Others say that the danger of imbalances in the global economy has been exaggerated, and that a "managed decline" in the dollar might simply erode the purchasing power of US consumers without fixing the mammoth US trade deficit.

"We've got capital coming into the US because the US has been growing faster than our trading partners. Why is that bad?" asks Michael Darda, chief economist at MKM Partners, an investment firm in Greenwich, CT.

The imbalances in global trade can be dealt with, he says, as export-centered nations develop stronger economies with more growth in consumer spending.

Many economists agree that a change in the currency value, by itself, is not enough.

The IMF, for example, announced in April its intent to work with several nations, including China and the US, on how to reduce imbalances.

Asian currencies may need to rise. But many see the problem as partly home grown in America, where both households and the government are net borrowers of capital.

A decline in the dollar, they say, coupled with belt-tightening by consumers and the federal government, could put the US on a sounder footing and ratchet the trade deficit down.

Harvard University economist Martin Feldstein calls this a policy of a "strong dollar at home" and a "competitive dollar abroad."

In the 1980s, for example, a falling dollar helped the US export more goods, while the rising cost of imports did not spark inflationary pressure at home. But being both "strong" at home (protecting consumer purchasing power) and "competitive" abroad (boosting US exports) could be tricky.

"The US over the next 10 or 15 years is going to be exporting a lot more and importing a lot less," says Dr. Kasriel at Northern Trust. That might not be as good as it sounds, he warns. "What it really means," he says, "is we're going to be working harder and enjoying it less."

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