Two weeks ago, it was the late night whisper by the Bank of Korea that they might start diversifying their reserve holdings --in central bank jargon, this means holding something (Euros) other than dollars -- that sent currency markets in a tizzy. But then the BOK cleared its throat and said that it really wasn't changing anything at all, folks had misheard. Once again, yesterday, some noises came out of the Bank of Japan that they, the world's largest holder of dollars, might be rethinking the composition of their reserve position and markets started to move. By nightfall in Japan, the BOJ made its denials heard loud and clear and dollar slippage stalled.

So what's going on around here? Let's start by calling it the dollar hot potato game and it's being played all over Asia. John Mauldin in a piece called Why Trade Imbalances Really Do Matterr compared it to playing the card game Old Maid. In Old Maid, if you remember, the idea is to get rid of the Queen of Spades. In each round the players pull a card from the hand of the player on their left. Pairs are discarded as the hand is narrowed down but there is no other black queen to match the old maid.

The Asian central banks hold several trillion dollars in their coffers. Since 1992 those dollars have lost more than 35% of their value in world markets. But these same Asian countries' economies are dependent on selling goods to the US. In some ways it's not the bloated old maid they're holding but the goose that laid the golden egg. The problem is that egg is getting less golden every day the dollar sinks against the value of the euro and, more literally, gold. The old maid analogy works because it becomes something of a nightmare for the central bankers in Asia to lose value on a day to day basis as the US trade imbalance widens. Nobody wants to end up holding all the dollars but at the same time nobody wants to be seen as sloughing off the queen.

This leads us back to today's news that once again, for the umpteenth time the US trade balance for a single month --January 2005) has hit close to a new record high. This time the deficit was 58.3 billion dollars. On an annual basis this would be close to $700 billion. What should be ringing warning bells is that this trade imbalance occurred after years of US dollar devaluations. Normally, when you devalue your currency it makes foreign goods more expensive and your own goods cheaper vis a vis the rest of the world. Over time that's supposed to bring the deficits down and a country's trade backinto equilibrium with the rest of the world.

The real short answer to why that's not happening is that we just don't make many goods in America any more so even if our prices would now be down there's nothing to sell. Of course, there's a lot more of it than that but it's a good start; The other key place to look is our internal consumer credit habits; Americans are willing to borrow more to buy more. They, (though not the credit card companies who lend them the money and who have just lobbied to get the bankruptcy laws tightened), just don't believe they'll ever reach a moment where they can't borrow against rising house values to bail themselves out. Just like Internet stocks in the 90's, housing prices have no ceiling.

So as long term interest rates finally (we say, finally not because we want them to move but because as the dollar falls US Treasuries will get harder to sell to those sleepless Asian bankers we talked about and they will demand higher rates of return) start to move up and mortgage rates start to follow, the housing well will dry up leaving a lot of debtors holding an
empty bucket.

Of course trade deficits and budget deficits haven't mattered much up to now nor has rising consumer debt --and BTW, it too was way up in January-- so perhaps they won't matter going forward. No one can say. Perhaps we in the US can just go on borrowing and spending forever. After all, the US is the world's strongest economy. As Treasury Secretary Snow said today, when faced with the trade figures, it's the rest of the world that's not pulling itsweight.

12:16:46 PM