This Could Be Fun

Things must be starting to look sort of grim for the mainstream press to be reporting on the impending financial crisis in the US. And the more it is reported, the more the rats start to flee the sinking ship, leaving fewer to bail and keep it afloat, and it sinks even faster.

From yesterday's BBC website:

The US dollar is plunging in world currency markets - and bringing down share prices in its wake.

But why is the dollar under pressure - and what would be the consequences for the US economy if it continues to fall?

Behind the problems of the dollar lies the huge and growing US trade deficit, and the large Federal budget deficit.

A fall in the greenback could hit Asian countries whose governments hold huge foreign currency reserves in dollars.

***

Together, the East Asian countries have accumulated foreign currency surpluses of nearly $1 trillion, much of it held in US Treasury bonds denominated in dollars.

Thus they are funding both the budget gap and the trade gap.

These huge global imbalances are threatening to derail the world economy, the IMF and other international organisations have warned.

***

In the first place, a rapid fall in the dollar, if it accelerates, could cause short-term problems for the US economy.

The higher price of imported goods could lead to a hike in domestic inflation, and it could take several years before consumers switch back to buying more US goods.

High inflation, combined with the stronger-than-expected growth of the US economy, could force the US central bank, the Federal Reserve, to keep raising interest rates.

They have already been raised 15 times, and now stand at 5%, partly on fears of a growing housing boom.

But the fears of inflation are also likely to affect the interest rates on long-term bonds, which determine mortgage rates.

The rising mortgage rates, while they may eventually dampen the housing boom, will also give a further boost to inflationary pressures.

***

As the value of the dollar falls, their reserves of the currency also reduce in value, as do the yields on the US Treasury bonds held by many of their central banks.

In buying such bonds these governments are, in effect, underwriting the large US Federal budget deficit as well.

This deficit is set to increase as the baby boomer generation faces retirement.

The Asian governments and investors may be tempted to sell many of their dollar holdings in order to protect themselves - but this would have the effect of weakening the dollar further.

And it would force the Fed to raise interest rates even more to protect the dollar.

I wonder if this will be the beginning of the end of the world's experiment of purely speculatory currency?