A Safe Haven's Risks by Fareed Zakaria

March 21, 2005 U.S. Edition

A Safe Haven's Risks
A crisis, like a large-scale terrorist attack, might send investors fleeing from dollars to other currencies
By Fareed Zakaria

The economics of the dollar make perfect sense. As other countries—notably in Asia—grow in wealth, they need to put their money somewhere. U.S. Treasuries are the obvious choice. Doing this keeps U.S. interest rates low, which allows Americans to borrow and spend—on Asian goods. In short, they save, we consume, both our economies grow, and everybody's happy. (Well, except the Europeans. Their currency rises, and their exports get more expensive. But they can't do much about it.) This is the Bush administration's stance. If the dollar falls over time, fine. It makes American exports cheaper and Asian imports more expensive, so Americans spend less and Asians more—a natural market adjustment that will create a new equilibrium. Last Thursday, Alan Greenspan added his voice to the "don't worry, be happy" school in a speech to the Council on Foreign Relations.

It's all logical and explains why there has been no crash of the dollar yet. But the world is not run solely by rational economic actions. Politics and psychology play a large role. And that's where worries are justified.

The current arrangement is not one created by market forces. Most Asian currencies do not float freely but have been kept artificially low so that Asian goods can be priced cheaply on global markets. This cannot last forever. Nor can Asian central banks keep accumulating dollars indefinitely, especially if those dollars keep falling in value. The Bank of Japan today has $840 billion in reserves. In the past two years it has lost tens of billions of dollars propping up the dollar. That's why South Korea and Japan have made noises recently about diversifying out of greenbacks—which produced immediate tremors in the market.

Everyone is uneasy with a complete reliance on one currency. The euro now gives the world an important non-dollar asset. Japanese officials actively talk about the need for an Asian currency bloc, which could serve as another alternative to the dollar. In other words, everyone assumes the current arrangement, in which the dollar totally dominates all central-bank portfolios, can't go on forever.

There's the danger. If everyone believes people will be selling dollars in the future, it creates a strong incentive for someone (a small country) to do it first, before the price plummets. In a fascinating essay, the economist Barry Eichengreen notes that the currency system of the 1950s and '60s collapsed because of a similar "defection" by France in 1968.

Perhaps most important is the growing sense of unease in the global marketplace about the United States' fiscal health. I asked a number of fund managers whether a political crisis—say, a large-scale terror attack—would move money into or out of the dollar. The view was surprisingly mixed. Historically the dollar has been the ultimate safe haven in times of trouble. But many now wonder whether that still holds.

"If a crisis shocks and thus slows consumer spending, what can the U.S. government do?" asked Mohammed El-Erian of PIMCO, one of the world's most respected fund managers. "The budget deficit is large, so the government can't spend its way out. We already know that entitlement spending will rise dramatically over the next few decades. The U.S. is running out of policy tools." This is why Greenspan has finally begun focusing on the budget deficit—rather late, given his endorsement of all the tax cuts that have produced this deficit.

In his speech last Thursday he pointed out that "the penchant of humans for quirky, often irrational behavior gets in the way" of seamless economic transitions. Let's hope no one gets too quirky over the next few years.