The dollar is under attack on two fronts:
- Private investors are driving it lower in the foreign exchange markets.
- Monetary authorities are questioning its role as the world’s key currency.
There is an obvious linkage between the two attacks – expectations of further falls in the dollar’s value accelerate the prospect that central banks will switch to euros, Special Drawing Rights at the IMF, gold, and other “real” assets. There is plenty of ammunition to fuel the attacks – over $20 trillion in dollar instruments held outside the US and much more owned by Americans themselves.
The common cause of these attacks on the dollar is the prospect of US budget deficits near or above $1 trillion annually for the next decade or even longer. Such deficits, especially in tandem with the unprecedented expansion of money and credit by the Federal Reserve to counter the current crisis, ignite fears of renewed inflation. More subtly, but at least as poisonous for the dollar, they suggest a crowding out of private investment that will lower productivity growth, economic output and corporate profits.
Such massive budget deficits would almost certainly produce massive trade and current account deficits as well. The enormous government spending, along with normal private consumption and investment after recovery from the current crisis, would far exceed potential domestic production and drive up imports of goods and services. Financing the fiscal and external red ink would require huge capital inflows that would sharply expand our foreign debt.
My colleague William Cline (2009) has projected that, with the present budget outlook, the US external imbalance could rise to $1 trillion per year by 2015 and to $3 trillion – almost four times its record level to date – by 2025. The net foreign debt of the US, which already exceeds $3 trillion, would reach $15 trillion by 2020. The expected doubling of the ratio of US government debt to GDP, to a level well above any prior US peacetime experience, would be matched by a doubling of our foreign debt to GDP ratio and take it far beyond the threshold that normally triggers currency crises and forces painful economic retrenchment. We would become even more perilously beholden to China, Japan, Russia, Saudi Arabia and our other foreign creditors (Bergsten 2009).
Hence there is an international as well as domestic imperative for bringing the budget deficit under control. There are two plausible, equally undesirable, scenarios if we do not.
- If the rest of the world proved unwilling to finance us, the dollar would fall sharply and perhaps crash. US interest rates, and probably inflation, would climb and the Federal Reserve would be unable to continue stimulating both the economy and recovery of the banking system. Stagflation or worse could result, as in the 1970s, and our currency would lose much of its remaining international status.
- If the foreigners did finance our profligacy for a while, as in the pre-crisis years, the conditions that brought on the current meltdown could easily be replicated.
Huge capital inflows would keep the economy excessively liquid and hold down interest rates. Even if financial reform is extremely ambitious, this could once again encourage excessive lending and borrowing. Large external deficits, and thus large budget deficits, will be extremely costly to the US whether or not they can be funded by international investors.
Implications for the dollar
We do need a modest further fall in the dollar, mainly against the Chinese renminbi and a few other Asian currencies, to restore full price competitiveness for the US in world trade and to sustain the decline in the current account deficit that has accompanied the recession. We should welcome a modest and orderly reduction in the international role of the dollar, which is inevitable because of the growing dispersion of economic and financial power around the globe, and because the “automatic financing” through which it encourages our external deficits is no longer in the national interest. We should in fact set a national policy goal of limiting our current account deficits to a maximum of 3% of GDP, which would keep our foreign debt from rising any further as a share of the real economy.
We must get our fiscal house in order to enable us to pursue these important national objectives in a reasonably stable environment as well as to avoid the catastrophic risks that would result from letting our foreign deficits and debt soar once again. Premature tightening, however, could choke off the fragile recovery. We thus need budget decisions in the near future whose implementation will mainly phase in over the next several years, as the economy returns to normal, but with sufficient “down payments” to be credible to both the markets and foreign authorities. The best candidates are reductions in medical costs as the central component of comprehensive health care reform; strengthening Social Security by further raising the retirement age and re-indexing the benefit formula; and initiating a consumption tax, perhaps on gasoline or carbon usage, that would achieve energy and environmental as well as fiscal goals and promote private saving.
The Obama Administration has rightly emphasised the need to rebalance the world economy and the shape of our own recovery, rejecting a return to the large trade deficits that have come with our being the “consumer of last resort.” It has made little effort, however, to enact or even propose domestic policies that would do so. Credible and lasting correction of the budget deficit is essential to protect our national currency against further attacks on its international value and its continuing vital role in the global monetary system.
Cline, William (2009). Long-term fiscal imbalances, US external liabilities, and future living standards in Bergsten (ed.) 2009.
Bergsten, Fred (ed.) (2009). The Long-Term International Economic Position of the United States, Washington: Peterson Institute for International Economics, April, 2009