My analysis of these “gaffes” is that there is a game of chicken going on between the Asian central bankers and the Bush Administration. The G.O.P. is discussing another $70 billion in tax cuts this year and no one believes that they will actually make any real cuts in spending. Since the Democrats have long ago ceased to be a real force of opposition to the economic tomfoolery of the tax cut-and-spend Right, the Asians are stepping in. Every time one of these central bankers accidentally on purpose discusses “diversification,” Treasury yields shoot up, taking with them the variable-rate mortgages. The calculation is that at some point domestic political pressure will build on Bush to do something about the twin deficits, and in doing so, strengthen the value of the dollar on which the Asian governments are so dependent.

We have been discussing just this very scenario for a few days now:
It certainly does look like a classic case of brinksmanship between the Asian central bankers and the Bush administration. Those states need the US to get their act together and, as Kevin rightly pointed out, at the present time there is next to no real pressure domestically for such change to come about. So esssentially they are "rocking the boat" just enough to to show the administration that they are willing to run great risks in order for the status quo to change. Also, these daily/weekly hiccups hopefully will cause previously unaware domestic actors to mobilize around this issue, putting pressure on the adiminstration to deal with both the current account and budget deficits. It will be interesting to see just how much the administration takes these 'threats' serioulsy--this hasn't necessarily been their strong suite...

I prefer "the Double-Oughts" when describing the current decade. Has that peculiar/threatening quality that seems to reflect the character of the decade itself. Like a shotgun load, y'know?

Dan, I'm wondering if your last comment doesn't beg the question. Doesn't Bretton Woods Two last only as long as these guys manage to keep it from falling apart under their feet? To Kevin--is it less of a game of chicken for an Asian CB insofar as its dollar position is relatively low compared to Japan's? This coordination ought to break down first at the fringes, right?

I don't think these are "gaffes," either. Pressure tactics, trial balloons, etc.

I am a little puzzled by those who suggest that the Bush administration "deal with" the current account deficit. How would they do that? Also, can it really be that the Asian governments want the U.S. current account deficit reduced? Won't that lead to unemployment in Asia, and, in China, riots and the overthrow of the government? The theory of inexperienced finance officials speaking carelessly seems much more plausible.

Y81: I understand you're speaking in hyperbole here, but there's no way the Chinese government is getting overthrown anytime soon, no matter how extraordinary the stimulus. That's a stable government. Better get used to it.

But yeah, I don't understand what people mean by Bush "dealing with" the current account deficit, either. What's he supposed to do to discourage imports and promote exports? Devalue the dollar? Umm...if I'm not mistaken...er...

What can Bush do? He can move to reduce the budget deficity by repealing some of his tax cuts and restraining spending. The current situation is an example of "twin deficits" in the budget and current account(which also happened in the 80's). Reducing one imbalance will reduce the other.

y81 and brooksfoe--good points all around. One thing I will say is that the problems created by the CA deficit (which may not entirely be the US's fault--I'll leave it to the more economically inclined of you to fight that one out), are exacerbated by our huge (and projected to get even bigger) budget decifit. This is certainly something our goverment (yes, dems and repubs) can actually work on--but it doesn't seem that either one has the political will, capital, or guts to deal with it--we cannot have our cake and eat it to--but alas, we seem to want exactly that. Tax cuts, increased defense spending, increased funding for social welfare programs, etc, etc...you add this all up and you get SCREWED. This isn't merely a "Bush isn't doing his job" issue--its both dems and repubs refusing to make tough choices and dealing with a deficit that is on trajectory to explode in the next decade...

Right, somehow the Democrats are part of this mess.

Remind me which part of the US government they control again?

bp32:

I really don't see how you can heap Democrats in with Republicans in assigning blame for this deficit. Nor do I see how you exempt Bush from reponsibility. This debt comes primarily from the repeated, massive tax cuts and Medicare prescription drug program, both of which were proposed by the Bush administration and passed by the Republican-controlled Congress. Bush and the Republicans are entirely responsible for our record deficit.

These are not gaffes. Foreign policymakers(FM) overseas are waking up to the realities of the American Fiscal situation. Their current economy's growth is dependent on Bretton Woods II and they no longer wish to hold or obtain more risk. If FM's fail to begin diverisfication they risk really holding the bag. The following is why.

The debate over Social Security and its dollar needs whether you attempt a privatisation or redeeem the Trust Fund will call for massive amounts of dollars(Greenspan is on record as saying anything over a trillion is a lot). FM's realize that raising taxes in America to supply them will reduce the growth in the US economy. The upcoming bankruptcy law change will reduce US spendable income as households pay down debt. FM's looking at the real costs of Medicare and Medicaid see more of the same. The current administrations foreign/military policies also mean spendable dollars diverted from FM's merchantile economies(The irony that this expenditure helps them is not lost on them).

The diverisification talk has multiple purposes. One, the attempt to diversify is to loosen some of the statist qualities of the European economies. Even if it is not possible in temperment to change spending habits in Europe any increase in spending on domestic goods in Europe expands the recycling of currency into another venue. That loosening the statist qualities of their own merchantile economies would help, has ironicly escaped them(I do realize this spending relative to the amount of output would be small individually in aggregate it would none the less help. If you can get bigger spending out of Japan the improvement would be substantial).

Two, it would help them keep their distance from the PRC policy demands. It is hard to blackmail their economies if they aren't holding outsize amounts of dollars.

Three, it is a call for the US to come up with a plan to get it's domestic economic affairs in order with a plan that gradually reduce our domestic debt.

The rub is how to do it.

... and, I should add, they will be entirely responsible if our country suffers from an unprecidented devaluation of the dollar due to Asian Central Bankers "diversifying" away from our increasingly-precarious currency.

Well, that is part of the problem. Bush has been pushing a free-lunch approach to Social Security reform that won't deal with the program's solvency outlook, and the Democrats have responded with a crusade to save the soul to their party by blocking any action at all on Social Security. The alternative -- action that would address the solvency issue -- involves unpopular benefit reductions and/or unpopular tax increases. Neither party wants to touch either one of these without a whole bunch of goodies to throw to the voters, but the goodie basket is empty.

A similar political dynamic affects the rest of the federal budget, but the trade deficit is a much bigger factor in the dollar's relative value than the budget deficit. Budget deficit reduction, desirable as it is, will not lead to Americans using less gas in their cars or buying fewer clothes made in China or cars made in Japan and Korea. And this is our dilemma: a currency adjustment (i.e. a dollar weaker relative to Asian currencies) would over time help reduce the trade deficit, but quite possibly not be enough to relieve pressure on the dollar to drop further. There are no large sources of American oil and gas to turn to if oil imported from Saudi Arabia and Nigeria becomes more expensive, nor are American industries likely to supplant textile, electronic and other imports from Asia, unless these become not only more expensive but a lot more expensive. Large increases in American interest rates would deter Asian central banks from dumping dollars, but would also cause a steep recession in the United States; the trade deficit would go down because trade would go down.

As we've discussed before on Dan's board, at the moment foreign central banks are buying dollars and propping up that currency's value for reasons other than return on investment. As long as that situation continues the pressure on Washington to act against the trade deficit should remain negligible. If the situation changes, action in Washington could come too late to avoid a currency crash and the return of substantial inflation.

"This isn't merely a "Bush isn't doing his job" issue--its both dems and repubs refusing to make tough choices and dealing with a deficit that is on trajectory to explode in the next decade..."

I don't think the two sides deserve nearly equal blame though. After all the GOP has controlled the WH and Congress for most of the last four years. Two of the big reasons for the deficits are the tax cuts and the Iraq war which have been pushed heavily by Bush in the face of significant Democratic opposition. And Bush is pushing to make the deficits much worse with this SS partial-privatization.

The Dems clearly share some of the blame when it comes to domestic spending but on the whole the responsibility for the deficits lies firmly with the ruling party.

And spending for which social welfare program has increased, again?

Be warned: if you say, "the Medicare Prescription Drug benefit," I will laugh at you.

Wow, if you don't heap all the responsibility on one guy somehow you are absolving him from any....my point was simply that regardless of how we got here (and I agree the tax cuts are largely, but not entirely responsible--I was suggesting collective blame) both sides need to take a seriously look at the budget and do some serious cutting. Are you prepared to tell me that dems won't fight tooth and nail to protect "their" programs? They don't like to spend with the best of them? Are they completely powerless, simply hanging around capital hill for photo ops? All I was saying was that both sides have their pet programs and cuts are going to have to come from both sides--thats all...not trying to turn this into a partisan debate, although it seems to be going in that direction...

...and as far as the Democrats go, their vigorous opposition to the war took place after they voted to authorize the use of force in Oct. of 2002 (over half the dems in the senate and over 1/3 in the house--without the Democrats it would not have passed the Senate). So, pass the resolution then complain about it later--I voted democrat and that pissed me off, it continues to piss me off. If they had serious reservations about the war then why do you sign on? For political reasons, granted, but that certainly isn't an excuse or one to be proud of--the last thing the Dems have done is be a true opposition party--they are groping in the dark hoping to find there way and I, like many who voted for their candidates, are getting pretty tired of it....

My point is not that the Dems are completely powerless or completely blameless but that they are clearly less powerful and therefore less to blame for what's happened to the budget in the last few years. There is always a temptation towards pseudo-balance and the claim that the blame for any problem is to be distributed exactly equally between the parties regardless of the facts. If one party deserves 75% of the blame for a particular problem, why pretend it's always 50-50?

As for the future Bush is pushing to make his tax cuts permanent and for hundreds of billions of dollars of more borrowing to fund SS personal accounts. In that context it's clearly wrong to blame domestic spending for future deficits unless you are supposed to abolish Medicaid or eliminate HUD or something.

The Asian economic policy makers find themselves in the same sort of dilemma a tavern owner in a port city faces when a shipload of sailors hits his town. Sure he is happy to have them splurge on his cheap ale; but at some point he needs them to stop making him rich and to sail away and fight that enemy lurking just over the horizon. The Asians fear more than anything a dollar collapse. Interest rates in the States would skyrocket; consumption of superfluous junk made in Asia would plummet and social problem would flourish.

The post-Cold War global economic order, featuring the rest of the world producing and saving, while America consumes, is unsustainable in its current state. The US is chewing up 80% (and rising) of global savings to finance her twin deficits. There is a limit here, despite what you may hear on Sports Center, there is no such thing as 110% in the real world.

The Asians need the US to get her economic house in order. This means balanced budgets, reasonable savings rates that can finance an inevitable 3% of GDP current accounts deficit. Ideally this would occur gradually, while the US consumer continued to buy Asian goods, albeit at perhaps a slightly reduced pace.

Of these three, for obvious reasons, the trade imbalance (which is not exactly the same thing as current account deficit but the two are linked) is the least of the Asian’s worries, since, of course, they have been instrumental in causing it and benefit wildly from it. Far higher on their wish lists are the budget deficits and savings rates. In order to reduce the trade deficit the Bush Administration needs to start pushing for fuel conservation and to continue calls for increases in domestic fuel production, including nuclear energy. Moreover, through tax policy, they need to encourage domestic production and higher savings rates. The single biggest factor though is that America needs to increase production of big-ticket items. Frankly I have no clue as to how a government goes about achieving this goal.

As for Jim’s question, the Asians are all exposed in different ways, ranging from Japan’s reserves to China’s need for US markets. I’m not sure that they are literally coordinating these “gaffes” it’s probably more likely that they playing off each other. In the end though, they all have the same long-term interests--namely, avoiding a dollar collapse by encouraging wiser US economic policies.

Strategist: point taken, my post shouldn't have suggested the blame is 50-50...

I don't know much about this, but there are two deficits. Bush obviously has some pretty direct control over the US budget deficit. And it's disingenuous to suggest that he has no control over the current account deficit. The levers he can pull might not be too attractive to him. (e.g. regulation/taxation of offshore activities) But they are there.

Coming back to the main issue I would like some analysis of whether the policies of the Asian cental banks make sense for their economies. Does it make to sense of park hundreds of billions of dollars in low-yielding Treasury securities as compared to other investments: both domestic and and international. Particularly when these dollar investments face a huge amount of currency risk.

I haven't looked at the matter closely but these policies seem to me to rest on the mercantilist fallacy that exports are good and imports are bad and that the government must artificially stimulate the former by keeping the currency low.

But a unit of GDP is a unit of GDP whether it's domestic investment or exports. Why artificially subsidise the latter? In particular should a capital-poor, labor-rich country like China be sending hundreds of billions of savings to the US instead of investing it domestically? Doesn't it make sense to increase domestic investment even it means lower exports?

A possible counter-argument is that there are important externalities in the export sector (perhaps in developing technological expertise) and that therefore it needs to be subsidised through currency management. Is that the reasoning of the Asian central banks? If so aren't there cheaper ways to subsidise exports than currency manipulation?

I tend to be a free-trader so I am skeptical of such mercantalist logic but if there is a good analysis of Asian central bank policies I would like to read it.

Strategist: I'm no economist, but if the Chinese are using their dollar holdings as a reserve asset, doesn't that mean they can issue more of their own currency and keep things stirring at home as they buy more US obligations?

But they never think of these things in only purely economic terms anyway. Those bonds are our short & curlies; increasing investment in Chinese assets by US-based companies is their collateral (or "hostage" if we prefer). They use the bonds to pressure us. If we give in, they buy more. If not, well, they can stop buying, provoke a dollar collapse, and simply seize some of those assets as compensation. Who could stop them?

The others don't have that option. But (without knowing any of the details how this would work) it seems to me that everybody has been playing a game of kick-the-can to make somebody else bear the costs of relative dollar devaluation. The Europeans had a bad run-up a while ago, but passed it off to the yen, which rebounded shortly after. Now it looks like OPEC is doing the job for everybody by ratcheting up oil and effectively devaluing the dollar that way. Can this work?

from Kevin de Bruxelles:
"The Asians fear more than anything a dollar collapse. Interest rates in the States would skyrocket; consumption of superfluous junk made in Asia would plummet and social problem (sic) would flourish."

Can someone explain why a dollar collapse would be so bad for Asia? The only reason I have been able to come up with is that the Asians, like everyone else, need to buy oil; and oil is traded only in dollars. No dollars, no oil.

Other than oil, what major purchase would the Asians need or want to make with their dollars?

As an earlier poster asked, why don't the Asians invest in their domestic economy? That is, why not have those factory workers make goods for the Asians to use, instead of manufacturing toys for McDonalds to give American kids along with their Happy Meals?

It seems to me that the answer has to be oil. They need those fresh dollars to buy oil.

It's almost as if the U.S. were still selling oil to the world, as they did in 1950, only now it's someone else's oil. The U.S. gives the world its fiat dollars, and the world give the U.S. goods of all kinds. Then everyone gives the oil countries dollars, which the oil countries use to buy more goods from Asia. Finally Asia, to keep the flow of oil and goods going, buys U.S. debt and thus effectively retires the extra dollars.

The result appears to be that the U.S. lives "for free" off the bounty of the world, as long as everyone else gets the goods and oil they need. The only difference is that all the other world's people have to produce something that some other country wants to make a living; ours don't.

This all seems very strange to me, but I can't figure out any other way to makes sense of it.

Can someone please set me straight? I am perfectly serious. I am trying to understand this.

Oil imports actually cut the other way, a cheaper dollar would make dollar-denominated imports cheaper and thus benefit Asian countries.

http://www.marginalrevolution.com/marginalrevolution/2004/06/not_my_idea_of_.html
I found this interesting post by Tyler Cowen last year about the issue. He gives seven reasons and says he thinks it's a bit of each. That's probably true but I have a feeling that an important reason is his last hypothesis: that the Asian central banks are simply making a big policy mistake in which case the US may be in for trouble if they wise up.

An additional reason he doesn't mention is simply inertia: having built up all those massive dollar reserves for whatever reason the banks don't want to do anything that will destroy their value. So they keep propping up the dollar. Of course at some point they may decide that enough is enough.

All in all a very delicate situation.

And spending for which social welfare program has increased, again?

Be warned: if you say, "the Medicare Prescription Drug benefit," I will laugh at you.

Dear Michael,

This is the rest of us, laughing at you.

The larger problem here has to do with the fact that we take money as some sort of given. It is a form of commodity. For one thing, only as much money can be saved as can be effectively invested, beyond that and it's just asset inflation. The stock market floats higher, whatever the P/E ratios. Interest rates sink, wantever the duration or quality. (High interest due to inflation is actually caused by a shortage of money being lent, as opposed to being spent.) The derivatives market is currently over three hundred trillion. This is really just a form of exotic wagering to hold infinite amounts of cash in solution.
The economy is a form of convective process, with materials, labor and ideas rising up. Wealth, order and security precipitate down. Far more is rising then is falling, so huge storm clouds of surplus wealth are building up at the top of the system.
Money is a tool, not a God. This turning the world's economy into a pedestal on which to pile huge quantities of cash for the high priests to rule over can only go so far before it topples over.
In ‘96, Bob Dole had a campaign slogan, “We want you to keep more of your money in your pocket.” My first thought was, ‘Thank God, it’s not my money, or it would be worthless!’
Money is a form of economic circulatory system, just like the highway system. As a note of public debt to its holder, it is essentially public property. A form of public commons, just like the highway system. What we have is a tragedy of the commons. It would be as if every time the government built a new road, everyone rushed out and claimed as much as possible. The result would be that they would have to pave over everything and the economy would still grind to a halt. This, in a more abstract fashion is what is happening with money. Rather then investing in a healthy infrastructure, education, public health and all the other public functions that the private sector needs to function, we simply pile it up in an inflated investment sector.
The purpose of Capitalism is to produce capital. It’s done a wonderful job. We have it coming out the ears, but the economy is still collapsing.

I appreciate the comments by Strategist and brodix. Thank you.

But I still don't think I got an answer to one very specific question.

Let me pose that question another way.

If the Asians did NOT finance the purchase of their goods by the U.S., and instead, say, redirected that portion of the output of their factories for domestic needs, then where would they get dollars with which to purchase oil?

Could they in fact purchase oil in their own currencies, or in Euros?

If they tried to do so, and perhaps succeeded, how would the U.S. react, economically, diplomatically, and militarily?

I'm not asking for a theoretical answer here -- "Oh, you just go to the American Express window and exchange a few billion RMB for dollars every week or so, then buy the oil you need."

I'm looking for a realistic scenario, one that could actually take place.

I think one of the main reason they continue to buy dollars is that they have so much invested in dollars. I'm going to stick to the Japanese case, because it is one I know a little about. Someone else can say if it applies to any other economies.

Bottom line; the Japanese invested heavily in the dollar when it was obviously the safest currency in the world, and failed to shift out in time. If they pulled out out now they would suffer a crash to end all crashes. Not only are a great many assets of Japanese banks in dollars. A great many of the Japanese companies they lent to have most of their assets in dollars. Suppose the Japanese banks started selling off their dollar assets tomorrow and caused the dollar to drop steeply quickly. If they did not succeed in selling before the dollar dropped, then they would no longer have enough reserve assets to match what is legally required for their loans outstanding. They would then be required to call in the riskiest of their loans, which would be unable to repay. This is due both to their debtors having high dollar assets and also to the the Japanese banks having made some very bad loans they never wrote off. A great many Japanese banks assets are loans that will never ever be paid back. So all of the sudden the loans they were forced to call in would be mostly written off - which would further reduce their paper reserves and force them to call more loans in. Bottom line, even not taking the dollar into account the Japanese are much closer to a 1929 type bank crash than is comfortable for the world economy. If the dollar lost a great deal of its value suddenly that would push them over the edge.

For the Japanese, survival depends on either propping the dollar up, or getting rid of their dollar assets slowly enough not to set off a crash, but fast enough to get rid of them while they still have value.

Other big dollar holders may or may not have the first problem - huge numbers of bad loans that have not been written off. But they have the second; their best course is either to prop up the dollar if it can be done indefinitely at a reasonable cost to them or get out of dollar assets slowly enough to get as much value for their dollars as possible. Two contradictory paths; and at this point I suspect they realize the U.S. is not willing to make any concessions to make the first worthwhile; that it is time for the second.

Get out, but slowly enough to stick some other sucker with those dollars at a price well above zero. If everybody decides this of course, the world will run out of suckers.

It is the old panic rules of speculations:

Rule 1) Don't Panic.
Rule 2) Panic First.

Ralph,
Not quite sure by what you mean by a "realistic scenario" but dollars can be bought and sold on the foreign exhange markets. So even a country which runs current account deficits could buy dollars to purchase oil. You don't need a CA surplus to buy oil. A fall in the dollar would by definition make it cheaper to buy dollars on the foreign exchange market. If you are asking about liquidity, forex markets are among the most liquid in the world with daily turnover in the trillions of dollars which is much more than requirments for oil imports.

Get out, but slowly enough to stick some other sucker with those dollars at a price well above zero. If everybody decides this of course, the world will run out of suckers.

It is the old panic rules of speculations:

Rule 1) Don't Panic.
Rule 2) Panic First.

Criminy sakes. You've elegantly described the pre-requisite for every bank panic this world has ever faced. And this is the rock-solid fundament our nation's greatness rests upon?

Churchill once set the pound sterling at the 1914 rate; unfortunately, this was in 1919. He was wrong, and the world economy charged a serious penalty for his folly.

What will be the price of Bush's folly?

Can someone explain why a dollar collapse would be so bad for Asia?

Because then American consumers would stop buying Asian products.

What will be the price of Bush's folly?

It doesn't look like we have long to wait to find out.

It brings to mind the old Greek saying; Those whom the Gods wish to destroy, first they make lucky.

Speaking of God, it doesn't seem to have occurred to anyone that the absolute is basis, not apex. So a spiritual absolute would the essence out of which we rise and to which we fall, not an all-knowing being from which we fell and seek to return. It would explain why stupidity is so much more common than intelligence.

This discussion of the "Don't panic vs. Panic first" quandary in the midst of a speculative bubble confronts the main question head-on: How do the Asian central banks gracefully diversify their currency holdings into euros and other denominations w/o losing their shirt in a dollar collapse? It's become pretty clear to them that the current Administration has no intention of reining in the deficit and is seriously contemplating even more draining and expensive wars again Syria and Iran.

I'd surmise that Japan, China, and S. Korea all have a sort of tacit "gentleman's agreement" with each other to slowly and cautiously diversify out of the dollar and into the Euro and other currencies. Major changes (e.g. China removing the dollar peg for the renminbi) will occur quietly and little fanfare. It'll all be behind the scenes so that when the excrement hits the fanblades, they'll suffer at worst tolerable damage and not be so exposed. The Japanese, of all people, should be smart enough to have learned a lesson from their own blunder: When they bought up so much US property in the 1980s, they had to sell it abruptly in the US recession in the early 1990s for a fraction of the buying price, losing billions of dollars to the original property-holders who essentially suckered the Japanese. Not quite the same thing with T-bills (and we'd be far more exposed) but I suspect they all know now not tp put all their currency eggs into the dollar basket.

Also, Ralph broaches a pertinent issue with the oil question. As others have noted I'm not so sure that is all that important, since it's so easy to make rapid exchanges on the forex markets and quickly toss dollars at OPEC to make the necessary purchases. However, since Nixon took us off the gold standard, it's essentially oil that's been backing the dollar. What we're witnessing right now is an inevitable shift away from the (almost) dollar monopoly on denominating oil purchases. Venezuela is already using a barter system for the same thing; Russia (which sells so much oil to Europe) is quietly moving toward a system to sell oil in Euros and other currencies; Iran is establishing an oil-based bourse for oil and natural gas sales; and Venezuela, Indonesia, Malaysia, and OPEC in general are starting to look more favorably toward collecting euros for their oil barrels since they'd be accumulating a more valuable currency that would be less vulnerable to the whims of a political leader with Wilsonian/quasi-Trotskyist fantasies of world revolution (at great expense).

So we're starting to hit downward-spiral territory here: The dollar loses value, loses much of its oil backing, which causes it to devalue further, which leads Asian Central Banks to nervously but quietly shift away from it, which devalues it further... No wonder that Bill Gates and Warren Buffett have started to pile up their own personal Euro reserves. I suspect that one clever little trick the ACB's have up their sleeves is to transfer the devaluing dollar problem to Saudi Arabia, with Japan, China, and South Korea gradually augmenting their oil reserves by exchanging their increasingly shaky dollars for invariably valuable Middle East oil. Which means that the Saudi royal family is left with the dollar reserve problem, which now the Saudis themselves are increasingly using to snarf up Euro-backed assets. I dunno, but I've been strongly considering a safe in some well-protected bank to stuff some euros into, b/c the next decade could get very ugly if the current policy course continues as is.

For people who don't believe the Democrats' don't have partial responsibility for the twin deficits issue, they have to look no further than the 2nd term of the Clinton administration when the trade deficit was doubling every year. A lot of this was due to the sudden drop of Asian currencies after the Asian financial crisis and the sudden influx of foreign investors' money into the US. The foreign money financed the trade deficit and pushed the dollar higher, making US manufacturers less competitive at home and abroad. Moreover, the influx of funds into US capital markets caused equities to increase in value, which generated a lot of capital gains. The capital gains through direct taxation as well as through multiplier effects generated a lot of revenue for the federal government that was in reality nonrecurring. The federal government didn't consider this income to be nonrecurring and assumed that the revenue would continue to pour in, and increased spending in response. When the collapse in the bubble came, the revenue generated by the bubble disappeared and helped create a deficit. Compounded with the Bush tax cuts and increase in defense spending, the budget deficit was pushed higher. Of course, I think the the budget deficit provides a foothold for foreign countries to manipulate the currency safely. Previously the only option they had was to buy equities and physical assets.

The Clinton administration should have realized that the surge in foreign investment would have an adverse impacts on the trade deficit and the competitiveness of US manufacturers in the short run. They should have realized that prolonged strength of the dollar would allow foreign competition to become entrenched. They should have done more to prevent the excessive increase in the value of the dollar and prevent the collapse of the Asian currencies. They should have done more to prevent the Asian countries from trying to export their way out of their problems.

IMHO, the only solution to our problem is to increase consumption taxes. I know liberals aren't going to like them because they are regressive, but the fact of the matter is that consumption taxes would do a lot more to decrease both deficits, without making American exports and American workers uncompetitive at home and abroad. I also suspect that poor and middle class Americans are responsible for a very large portion of the trade deficit, so it seems that they will have to bear the costs of adjustment, which will involve higher prices due to either taxes or a weaker currency. However, by raising consumption taxes and reducing production taxes they would stimulate more export industries and an increase in jobs in those industries, many of which tend to be high paying because of the skill sets required.

As for why the Asian banks continue to prop up the dollar, it is because their governments have built their economies around selling products to foreign customers as opposed to domestic customers. Also I suspect they fear how ultracompetitive the US manufacturers would become if the dollar would weaken. They would lose their markets and potentially see signficant encroachment by US manufacturers in their markets.