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Morgan Stanley’s former Asia Chairman Stephen Roach and Bridgewater founder Ray Dalio, among others, have recently warned that the US dollar may lose a third of its value. A chronically low savings rate, a large current account deficit and a huge federal financing requirement, Roach argued, will force a sharp devaluation of the US currency.
Declining empires and declining currencies stumble along until something comes along to put them out of their misery. Post-WW2 Britain is a case in point. Once the dominant world power, it issued the world’s main reserve currency and ran a chronic current account deficit. It allowed its industrial base to deteriorate and its skills to stagnate. The market for British assets eventually cleared as the British pound fell by almost two-thirds between 1967 and 1985.
Without a fundamental change in Washington’s attitude towards US industry and technology, something like this will happen to the dollar as well.
Today’s challenger is China.
From 8.28 to the US dollar prior to 2005, the Chinese yuan rose to just above 6.0 by 2014. It’s hit some turbulence since then. But a look at the US and Chinese currencies’ fundamentals shows that the recent march from 7.15 to 6.75 will have staying power and lead 6.00 in the medium term, in the course of 2021. The longer-term target is a 30% rise to 5.00.
The symbiosis between the US and China that pundits used to call “Chimerica” is dissolving, and the result of this dissolution will be a drastic depreciation of the US dollar.
The world’s two largest economies enjoyed (or suffered from) a symbiotic relationship during the past three decades. China saved and invested, America borrowed and consumed. China (and South Korea, Japan and Taiwan) built the plant and equipment that produced the industrial products that America consumed.
China’s high savings rate created a chronically high current account surplus, while the United States had an extremely low savings rate and a correspondingly large current account deficit. China wanted to accumulate reserves and the United States wanted to buy consumer goods. The reserve-currency status of the dollar drew China’s savings into US capital markets.
China and America in key respects thus are mirror images of each other. The rise in China’s national savings rate was matched by a decline in America’s national savings rate.
Household consumption forms a larger proportion of GDP in the US than in any other big industrial country except Britain, at 70% of GDP compared to an OECD average of 60% of GDP.
China’s desire to save and America’s desire to spend created “Chimerica,” or what one might call American capitalism with Chinese characteristics.
- China ran a chronic trade surplus with the United States and invested the proceeds in US capital markets;
- China kept relative prices for its goods low in order to gain export market share;
- China invested in manufacturing capacity and industrial infrastructure while the United States reduced investment, such that Chinese savers made the investments required to supply the US with industrial goods;
- The composition of US GDP shifted towards consumption and away from investment.
America made a decision not to invest, and Asia (China, S. Korea, Taiwan and Japan) did the investing for America.
Prompted by the deterioration in US-Chinese relations as well as domestic political considerations, China is shifting towards a regime of lower savings and higher consumption. That requires a corresponding structural change in the other half of Chimerica which, however, the United States is ill-prepared to accomplish. That leaves the exchange rate as the only mechanism of adjustment.
First, let’s review the facts.
The capital intensity of China’s economy increased drastically during the past 40 years while the capital intensity of the US economy declined.
America’s GDP shifted towards consumption (70% of total vs. an OECD average of 60%):
As the US savings rate declined, the current account deficit widened.
The capital intensity of the Chinese and South Korean stock exchanges, correspondingly, increased while the capital intensity of the S&P 500 remained static.
The sudden collapse of household consumption and corresponding jump in the savings rate caused by the pandemic lockdown revealed the inherent fragility of an economy heavily skewed to consumption. Precautionary savings during the pandemic lockdowns raised the personal savings rate to a never-before-seen 18% of GDP, and the volume of savings doubled from the level prevailing during the 2010’s.
Gross private saving rose from $5 trillion to $8 trillion at an annual rate. Gross private investment meanwhile fell to a $3 trillion annual rate. The jump in the 2nd quarter savings rate, to be sure, corresponded to a 32% annualized rate of GDP decline.
The American economy collapsed at an unprecedented rate when American households stopped spending. To compensate for the jump in saving, the Treasury and Federal Reserve dis-saved by spending trillions of dollars on income subsidies and direct purchases of securities. This had the same effect as pumping air into a leaky balloon. The massive increasing in Federal spending and the expansion of the Federal Reserve balance sheet restored part of the lost consumption (still running about 6% below 2019 levels), without contributing in any way to future economic activity.
Domestic savings and the Fed balanced sheet financed the flood of Treasury debt issuance, unlike the situation after the 2008 crisis, when foreign investors increased their holdings of US Treasuries.
The US can’t sustain a high savings rate without a severe decline in economic activity. Meanwhile government dis-saving will remain extremely high. The willingness and capacity of foreigners to send savings to the US has diminished. Something has to change, and that something is the exchange rate: US assets have to cheapen sufficiently for foreigners to buy them. Rising inflation also will motivate higher savings (as wealth declines, individuals save more to compensate).
A decline in China’s propensity to save implies that the United States must save more. As noted, that is exactly what American households and corporations did at the outset of the pandemic lockdown. But household savings was counterbalanced by government dis-saving. The US is suffering from a version of the “Red Queen effect,” as in Alice in Wonderland: It has to spend faster just to remain where it is.
In principle, the United States could introduce incentives for high tech investment (tax breaks for capital-intensive industries, R&D tax credits and subsidies, and so forth) to make capital assets more attractive and encourage savings for the purpose of investment. This sort of approach doesn’t appear to be on the agenda of either political party.
The other way to correct the savings deficit is through dollar devaluation and inflation. A cheaper dollar will reduce consumption by increasing the price of imported consumer goods, including the consumer electronics that comprise the lion’s share of America’s imports from China. It will also reduce the price of American capital assets including Treasury securities, and encourage foreigners to buy them – after the dollar hits bottom. Inflation, as Prof. Robert Mundell observed in a classic 1965 article, also prompts individuals to save more, because it reduces their wealth, leading them to save more to compensate.
That’s why a devaluation of the dollar on the scale of the long, sickening slide of the British pound, currency of a Britain once Great, is the predictable fate of the US dollar.