GOING DOWN; COMMENT Series: 1/5

John Cassidy. The New Yorker.

Americans long ago became accustomed to the pleasing notion that there is nothing quite so sound as the dollar. During the nineteen-twenties and thirties, when Pound, Hemingway, and Stein were in Paris, they lived on modest remittances from home which, translated into francs, bankrolled lazy afternoons in the Jardin du Luxembourg and giddy evenings on the Boulevard Montparnasse. "Two people, then, could live comfortably and well in Europe on five dollars a day and could travel," Hemingway wrote. Near the end of the Second World War, an international conference in Bretton Woods, New Hampshire, confirmed the American currency's role as the linchpin of the global economy, setting up a system of fixed exchange rates that survived for almost thirty years, and ushering in an age of unprecedented international prosperity. John Maynard Keynes, the leader of the British delegation, acknowledged the new economic reality. He and his fellow-Brits might have the brains, he is said to have commented, but the Americans had the money.

Not anymore, as anybody who has visited Europe recently will confirm. Five dollars for a cup of coffee, a hundred dollars for a mediocre meal, three hundred dollars for a modest hotel room--if Hemingway had been forced to pay such prices, Paris would loom less large in the history of American letters.

Since the nineteen-seventies, the dollar's value has been determined in the financial markets, where traders buy and sell currencies like any other commodity. In the past few weeks, the dollar has fallen sharply. The depreciation reflects two intractable, and related, problems. First, as manufacturing and production have shifted to countries with low labor costs, the trade balance has declined alarmingly: America cannot sell as much abroad as it buys. Second, the United States has emerged as the world's biggest debtor. Ten years ago, the country ran a modest trade deficit (less than a hundred billion dollars), and, as a consequence of investments that Americans made overseas, the rest of the world owed us trillions of dollars. Today, the trade deficit is about five per cent of the gross domestic product--bigger than it has ever been--and we owe the rest of the world about three and a quarter trillion dollars.

Running a trade deficit and borrowing from abroad, even borrowing heavily, aren't necessarily bad things. Many developing nations do so because they don't have enough capital to invest in industrial equipment, education, and infrastructure. But the United States isn't a developing nation, and it isn't borrowing to finance investment: it is taking on debt to finance the government's day-to-day expenses, and to pay for imported consumer goods, such as autos, toys, and electronics.

The dollar's fall, along with the trade and budget deficits, is a classic symptom of a country living beyond its means. Twenty years ago, American households saved about nine cents of every dollar they earned; today, they save less than a penny. The federal government is spending about four hundred billion dollars a year more than it raises in taxes, which means that the Treasury has to sell about thirty-four billion dollars' worth of bonds every month to remain solvent. By far the biggest purchasers of Treasury bonds are the central banks of China and Japan, which, last year alone, accumulated some four hundred billion dollars' worth of them. Since the purchases were made in dollars, they also provided much needed support for the currency.

Hardly coincidentally, China and Japan run the biggest trade surpluses with the United States. To maintain export-led growth in their own countries, both governments have been financing the American budget deficit and preventing their currencies from appreciating against the dollar. Some observers have labelled this arrangement a "new Bretton Woods"--we import consumer goods from Asia, and they lend us the money to pay for them, at fixed exchange rates. The system worked for a while, but, at some point, all countries have to pay their own way, which means restoring the trade balance and paying down debts. One way to do this is to cut back on imports by reducing consumer spending, but this would probably require a recession. The only other option is to devalue the currency, which makes imports more expensive and exports cheaper.

In recent weeks, John Snow, the Treasury Secretary, and Alan Greenspan, the Federal Reserve Board chairman, have made statements that can be interpreted as attempts to devalue the dollar. Not surprisingly, their comments prompted more selling on the foreign-exchange markets. But debasing the dollar is a high-risk strategy. Currency movements tend to be self-reinforcing. If traders come to see the dollar as a one-way bet, its slide could turn into a rout. During the past decade, record trade deficits, soaring foreign debts, and prolonged fiscal irresponsibility presaged full-blown currency crises in Mexico, Russia, Brazil, and many other countries. The crises eventually erupted when foreign investors rushed to get their money out of the stricken countries. If that were to occur here, the Federal Reserve would be forced to raise interest rates in order to stop the panic selling, which, in turn, would torpedo the stock and the real-estate markets. The economy would be plunged into a deep recession.

Given the dollar's unique status as an internationally accepted means of exchange, many economists doubted that such a catastrophe could befall the United States. Now they are not so sure. Russia just announced that its central bank might change some of its dollar reserves into euros, and rumors persist that Saudi Arabia and other Middle Eastern oil producers will soon begin to set oil prices in euros, a move that would undermine the dollar's privileged status. Most ominously, the Bush Administration has alienated some of the dollar's biggest supporters by trying to deflect responsibility for America's growing financial dependency onto China and other low-cost producers. Last week, Li Ruogu, the deputy governor of the People's Bank of China, told the Financial Times, "China's custom is that we never blame others for our own problem. The United States has the reverse attitude. Whenever they have a problem they blame others."

Ultimately, the value of a currency is an international verdict on the honesty and competence of the government that issued it. President Bush may have recovered in the domestic polls, but in the currency markets his ratings are still falling. And, with his Administration determined to pursue further tax cuts and costly Social Security privatization, his numbers don't seem likely to turn around soon.