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(3/24/2003 - Prestowitz) The Unmightly Dollar

The Unmightly Dollar
By Clyde Prestowitz
22 March 24, 2003
(Copyright (c) 2003, Newsweek

A costly war could drive more foreign investors away from the United States, hurting living standards and our influence abroad

As America prepares for war, all eyes are fixed on the capabilities of its troops and high-tech weapons. Less noticed is an Achilles' heel that is likely to be made a lot more tender by the war, with important negative implications for future U.S. living standards-and influence.

WHILE THE UNITED States is the greatest power the world has ever seen, it is also the greatest debtor, living beyond its means and heavily dependent on foreign lenders. For years America has been importing more than it exports. These "current account" deficits have now reached an annual rate of $500 billion, or about 5 percent of GDP and 50 percent more than the United States spends on defense. America has been paying for the difference by borrowing. In this case, the money has to come from foreign lenders because the buying that generates the deficits is done abroad. The debt America owes abroad has now reached about $2 trillion, or about 20 percent of GDP. At its current growth rate, total U.S. foreign debt could easily top 65 percent of GDP by 2010. Even with interest rates of only 3 percent, it would take nearly $200 billion annually for the United States simply to finance the debt.

The deficit ultimately arises because America saves far less than other countries, and the war is about to make that situation a lot worse. Economist Martin Wolf has conservatively estimated the cost of the war and of rebuilding Iraq over a 10-year period at $156 billion to $755 billion. Other estimates have run as high as $3 trillion. In the 1991 gulf war, most of the cost was paid by other countries. This time, the United States will have to bear most of the burden itself. Without new taxes, this will greatly increase the U.S. budget deficit.

For a long time it has been relatively easy to get the foreign funds as overseas investors have rushed to buy U.S. stocks, bonds, real estate and companies. During the tech bubble of the 1990s America became the location of choice for investors from countries with large international reserves, such as China, Taiwan, Japan and Western Europe. The flood of money buoyed the dollar and stocks, allowing Americans to live beyond their means by consuming more than they produced.

More recently, however, there has been a significant change in the flow of the foreign funds that is as critical to U.S. economic health as the flow of oil. Over the past year, private foreign investment in the United States has fallen dramatically. It has been partially offset by increased buying of U.S. Treasury notes by Asian governments. But, at the same time, some governments like Russia have also begun to shift some of their reserve currency holdings from dollars to euros. As a result, we have seen the dollar fall in value against the euro by about 25 percent. That kind of a decline occurs when foreigners decide to put their money someplace other than the United States. U.S. international debt is getting so large, foreigners become nervous about their holdings and cut back on buying.

Thus, the biggest casualty of the upcoming war with Iraq may be the U.S. economy. A dramatic increase in debt could result in a fall of the dollar that would reduce U.S. living standards while significantly increasing the cost of projecting U.S. power abroad. The only way to avoid this scenario is by raising taxes, something that will also reduce living standards. Another option is to become more dependent on lenders like China and Saudi Arabia. Either way, U.S. power may not loom nearly so large as many now imagine.

Prestowitz is president of the Economic Strategy Institute and author of the forthcoming book "Rogue Nation."

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