Several months into the U.S.-led occupation of Iraq, frayed trans-Atlantic ties show no signs of mending. Last week, having failed to make any progress on its own, the Bush administration brought former Treasury Secretary James Baker off the bench to negotiate a workout of Iraq's debt, much of which is held by France, Germany, and Russia. This week, the Pentagon explicitly banned France, Germany, and Russia from bidding on reconstruction work in Iraq.
Of course, the United States needs European cooperation to finance something even more crucial than the reconstruction of Iraq. We rely on Europe—Old and New—to finance our private companies and, to a lesser extent, our government. After all, the United States' biggest exports today aren't movies or software programs. They're paper products—stocks, bonds, and other securities. The Europeans are among the biggest purchasers of these goods. But recent data and recent currency market action, which has seen the dollar plummet to record lows against the euro, suggest our erstwhile continental friends may not be buying what we're selling. If that continues, it could spell trouble for the already weakened dollar.
The United States exports dollars to buy food, oil, and manufactured goods. Our foreign trading counterparts tend to send dollars back to America by purchasing U.S. government bonds, U.S. dollars, so-called agency debt—which consists largely of mortgage-backed securities—and corporate stocks and bonds. By recycling the capital we export, foreigners fund our debt, keep interest rates low, and keep currency ratios relatively stable. In 2002, foreigners bought a net $547 billion in U.S. assets. In the first nine months of 2003, they purchased a net $523 billion in U.S. assets. (To see the data, go here and open the file as a Microsoft Word file. Chart CM-V-1 shows totals for the last several years; CM-V-3 breaks down the data by country and region.)
The main sources of capital are Europe and Asia. Asia—particularly Japan and China—accounts for a decent chunk of U.S. government and agency debt. But the private sector relies largely on Europe, the broad swath of countries from Turkey to Great Britain. In 2002, Europe accounted for nearly two-thirds of net corporate stock sales and 60 percent of net corporate bond sales. This chart shows that the United Kingdom is our most stalwart ally in economic matters, in addition to geopolitical ones.
Since the beginning of 2002, the dollar has fallen by about 25 percent compared with the euro. That means an espresso at that café just off the Ponte Vecchio in Florence now costs an American tourist $2.50 instead of $2. On the flip side, European purchasing power is higher in U.S. markets than it has ever been. As a result, one might expect European purchases of dollar-denominated goods—whether they're Disneyland tickets or Disney's stocks and bonds—to be growing.
But in September, as chart CM-V-1 shows, net foreign purchases of U.S. assets were less than $16 billion, down dramatically from $62.4 billion in August and $75 billion in July. In September, Europeans collectively sold about $400 million in U.S.-denominated assets.
Are Europeans going on a buyer's strike in a fit of pique over Iraq? Not necessarily. For the first nine months, inflows from Europe were $224 billion. And one month's data does not a trend make. But more recent data isn't exactly encouraging. Last week the Wall Street Journal reported that "at November's auction of two-year U.S. Treasury notes held last week foreign investors bought just 32% of the $26 billion issue. That compares with the 42% foreigners snapped up at October's auction of the same size."
Low interest rates—which tend to dampen demand for the dollar—are partially to blame. And the actions of the administration's economic team aren't helping. Treasury Secretary John Snow has ineptly tried to talk down the dollar, knowing that the weak dollar would be good for domestic manufacturers and help counteract the trade deficit—all the while, of course, insisting that the United States remains committed to a strong dollar. For his part, President Bush has tried to discourage Japan and China from weakening their own currencies—which they do by buying U.S. government securities and dollars—even as he's racked up huge deficits, a policy that in turn requires ever greater sales of government bonds. (Even after virtually every original member has been replaced, this economic team still hasn't demonstrated it knows how to play the game.)
To a degree, in fact, the decline of the dollar against the euro is a logical outcome of our policies. Winking at a weak dollar surely doesn't encourage foreign investors to jump in. Why buy something today when you think it'll be worth less tomorrow? Our interest rates remain remarkably low, with Federal Reserve Chairman Alan Greenspan yesterday signaling he won't raise them anytime soon. It's obvious to European investors that they can get higher rates of return on government debt in stable economies elsewhere.
The dampening of European interest in U.S. stocks is perhaps the most mystifying aspect of the story. In the late 1990s, European investors piled into the runaway U.S. equity markets, snapping up the stocks of profitless dot-coms and revenueless fiber-optic companies with the same abandon that we did. But in this miniboom, even with the U.S. markets at or near their highs for the year, the Europeans are remaining aloof. Either they're missing out on huge profits, or, like American tourists nervously translating pounds into weaker dollars at Harrod's, they've just become more discriminating shoppers. If we're going to rely on foreigners to finance our boom, it may be worthwhile to treat our funders' concerns with something more than contempt.