Suppose that one of the Asian banks starts to dump its reserves of American currency. This extra supply of U.S. dollars would lower the “price” of the dollar-the exchange rate between the U.S. dollar and other world currencies. Other major players may be tempted to sell their own dollars before they lose more value, creating a speculative cycle and a rapidly dropping exchange rate. The price of imports would rise, increasing the cost of living and of doing business. This increase could create a major recession. Furthermore, higher prices may encourage the Federal Reserve to raise interest rates to prevent an inflationary cycle from taking hold. This would worsen unemployment and increase the amount of the interest paid on the national debt. The U.S. government would have to choose between spending cuts on a large scale or tax increases. While it is extremely unlikely that a currency crisis could destroy our economy to the extent that it did in Argentina, for example, the risk of catastrophic loss is probably as great now as it has ever been in our lifetime. Even a one percent chance should terrify Americans.
While the doomsday scenario is a fairly remote possibility, it is almost certain that there will be a readjustment in the near future. The U.S. is importing many more millions of dollars worth of goods than it exports. Running a trade deficit is not in itself a bad thing. There is no reason not to borrow on the expectation of future income. However, the expectation of future productivity is declining. Investment is being squeezed under the colossal debt-financing needs of the federal government. This debt-financing absorbs money that would otherwise be available for businesses to invest in new factories and technologies. Furthermore, the increased proportion of our GDP spent on debt payments decreases faith in our ability to finally repay that debt. Consequently, foreigners are less willing to become our creditors. Finally, the larger the debt we create, the more painful it becomes to raise interest rates because doing so raises the dollar value of the interest of the government’s own debts. Thus, foreigners expect future U.S. interest rates (and thus the income on American financial assets) to be less than they would otherwise be. For these three reasons foreigners are less willing to accept such assets in exchange for the goods we import. Consequently, America’s international buying power falls.
Enter the central banks of the major Asian economies. They have been buying up dollars on the international markets, driving up the dollar’s buying power and stimulating Asian exports. These actions have made our currency artificially strong. While it may be in the short term very pleasant for China and Japan to bankroll our spending, their actions have created a large gap between the natural market value of the U.S. dollar and its actual value. With such a gap there is a potential for a sudden fall.
We have good reason to suspect that the current state of affairs will not last much longer. First, as discussed above, the dollar is sliding for independent reasons. This makes it more expensive to hold large reserves in dollars. Even as Asia buys up our currency it declines in value. It is difficult to believe that our cross-Pacific creditors are glad to see us taking money from their pockets to feed the gaping maw of irresponsible spending. Second, it may be that some of the Asian banks’ motive to hold up our currency are expiring. China may soon no longer feel that it needs a low yuan to stimulate exports. Last month they raised interest rates for the first time in many years, which might signal that they are trying to prevent their economy from overheating. Furthermore, it may be true that some of the Asian banks were buying dollars to rebuild reserves which were decimated by the Asian Crisis. Having done this, their demand for dollars should diminish.
Most commentators seem to think that there will be a major readjustment within the next decade. When this happens, the U.S. economy will be hit hard. In order to compensate for the greater scarcity of investment capital the Federal Reserve will be forced to raise interest rates. This contractionary shock to an already fragile economy will increase unemployment and raise the cost of living in the short term.
Furthermore, there is a chance of meaningful long-term losses if the shock is great enough to diminish confidence in the dollar as a stable store of value. Much of world trade is conducted in dollars, and foreign governments choose to hold large reserves of dollars because of the great degree of confidence in the stability and value of U.S. currency. The dollar is the modern world’s equivalent of gold and controlling its production provides benefits analogous to those of owning all the world’s gold mines. However, for the first time since WWII there is a credible alternative as an anchor currency. If markets substantially switched over to the Euro, we would lose the rents that come from controlling the globe’s barbarous relic of choice.
The U.S. Government and the Federal Reserve need to acknowledge the threat created by the current-account crisis. The fiscal deficit ought to be reduced and interest rates allowed to rise to minimize the cost to foreign central banks of holding dollars and thus the risk of sudden movements. While these actions may be slightly painful in the short term they are necessary to ease the dollar to a soft landing on its natural market value. The United States of America should not be in a situation where it is reprimanded by the IMF for irresponsible behavior. There should not be a significant threat of a run on the dollar. Our government is jeopardizing America’s future, and it needs to stop.
Borowsky can be reached at [email protected]