On Wednesday, 17 May, the Dow Jones plunged 214 points to 11,206 -- its worst point drop since March 2003. The downward trend started two weeks ago and is a warning sign of troubles ahead.

This sudden drop has come as a complete surprise to the unfortunate small investors and speculators. The so-called �experts� point at the sudden threat of inflation as the main cause of the recent reversals in the markets.

What is actually surprising is the surprise of the �experts." A cursory look at the United States� finances will reveal the amount of pressure that its economy is under.

When Bush became president in 2001, the United States� public debt was $5.8 trillion. Today the public debt stands at $8.3 trillion [1]. Of this over $2.2 trillion are held by foreigners [2]. The United States has a GDP of $12.4 trillion . This gives the U.S. a Debt/GDP ratio of 66 percent, placing it in 35th place (out of 113) on the ranking of the Debtor Nations [3]. The current account deficit of over 7 percent has long passed its danger levels of 4-5 percent. In 2005 the U.S. government paid $325 billion in interest payments alone.

Then there are the future obligations such as Medicare, Social Security and government pensions. These obligations amount to $54 trillion. This huge problem worried the former Federal Reserve Chairman Alan Greenspan. He told congress: �As a nation, we may have already made promises to coming generations of retirees that we will be unable to fulfill� [4].

One would think that this amount of debt would worry the president and the congress. But apparently it does not. The United States� Congress recently (March 2006) voted to increase the federal debt limit to $9 trillion . Any other nation in similar circumstances would have had to approach IMF for help. IMF would then have forced that nation to cut spending and devalue its currency. But the U.S. does not need to do this. The U.S. can just print some more dollars. But how long can this continue before the world loses faith in the greenback, sending it crashing to unimaginable levels.

The Asian Lender

The Asian countries such as Japan, China and others that hold most of the U.S. debt have been happy to indulge the American deficit spending. This has been a two-way street: America has kept its market open to their products and they have financed the Americans� spending.

The value of the U.S. dollar, so far, has been kept artificially high by Japan, China and oil-exporting countries. These countries by buying US debt have kept interests rates relatively low in the United States and allowed Americans to keep spending even as their debts mount.

But there is only so much risk these lenders (Asian and oil-exporting countries) are willing to take. Any serious devaluation of the dollar will considerably reduce the value of their national reserves (mostly kept in dollars) and the value of their debt holdings (certificates, bonds, etc.). At the same time, the devaluation will affect their exports to the U.S. A weaker dollar makes their products more expensive in the U.S., thereby reducing their export earnings. Most Asian countries keep up to 70 percent of their reserves in dollars. China with reserves of over $800 billion has already begun to slowly reduce its dependency on dollars by converting part of its reserves to other currencies [5].

If other Asian countries -- with their vast dollar holdings- follow suit, then it will be disastrous for the value of the dollar. No one is interested in holding a weakening currency.

Petro-Dollar

Another threat against the dollar comes from countries such as Iran and Venezuela. Iran recently registered an oil bourse to compete with bourses in New York and London. The threat comes from the currency in which the oil is to be sold: euros. Iranians are going to make the euro the standard currency for oil transactions. Some sympathetic countries such as Venezuela and others may join in. If the Iranians succeed in this, the pressure on the dollar will be catastrophic. Nearly every country has to hold a certain amount of dollars in reserve for oil purchases. If the dollar continues to weaken in value, and there is the possibility of purchasing oil in euros, then these countries would unload their dollars for safer currencies such as the euro. What will then happen to the value of dollar?

Iraq and Iran

As though there is not enough pressure on the dollar, the U.S. government keeps spending money in an unwinnable war in Iraq and is considering starting another one in Iran. The total cost of the Iraq war, including the future payment to disabled soldiers, replacement of equipment, etc., is estimated to be between $1 to $2 trillion [6].

Any attack on Iran will substantially increase this cost. Even if there is no attack, the tense situation in the region will keep the oil prices at uncomfortable levels, contributing to both a reduction in U.S. growth and an increase in its deficit.

Conclusion

The current American deficit and its long-term financial obligations, if they go unanswered, will sooner or later lead to either a marked increase in interest rates or a substantial devaluation of the dollar. On one hand, a substantial increase in interest rates will lead to a major recession in the USA that will be felt immediately around the world. On the other hand, a substantial devaluation will cause financial chaos in the world. What is needed is to seriously reconsider the international role of the dollar as the world currency. In other words we need a new Bretton Woods Agreement [7].

At the end of the WWII, 45 nations gathered at a United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire, to address the problems of reconstruction, monetary stability and exchange rates.

The delegates agreed to establish an international monetary system of convertible currencies, fixed exchange rates and free trade. To facilitate these objectives the delegates agreed to create two international institutes: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank). An initial loan of $250 million to France in 1947 was the World Bank�s first act.

Since then there has already been considerable criticism of the roles of IMF and the World Bank. The above mentioned problems and the ongoing trade imbalance in the world have to be addressed by a similar gathering. Sooner or later, both the United States and the rest of the world have to address the existing problems. These problems are not the United States' alone. We cannot ignore the largest economy on earth. It is said that if United States sneezes, the world catches cold. We have to either make sure that the United States doesn�t catch cold or vaccinate ourselves against it.

Endnotes:

[[1]] Bureau of the Public Debt, �The Debt to the Penny�

[2] Hodges Michael, Grand Father Economic Report Series

[3] CIA Word Factbook, �Rank Order - Public debt,� 16 May, 2006

[4] USA Today, �The looming national benefit crisis,� 5 October 2004

[5] Washington Post, �China Set to Reduce Exposure to Dollar,� January 10, 2006-05-18

http://www.washingtonpost.com/wp-dyn/content/article/2006/01/09/AR2006010901042_pf.html

[6] Bilms Linda, and Stiglitz Joseph E., �The Economic Costs of the Iraq War: An Appraisal Three Years After The Beginning of The Conflict,� Harvard University

[7] Yale Law School, The Avelon Project, �The Bretton Woods Agreements�