Death Cometh for the Greenback
From the November/December issue of The National Interest.
THE DOLLAR is in trouble. That's clear, and it's been true for a while.
The cornerstone of the global economic system has long been the greenback. In the aftermath of the Vietnam War and the oil shocks that brought on inflation, the value of the dollar relative to other currencies could not be maintained, so countries moved away from pegging their currencies to America's. But still, the almighty dollar was used by countries all over the world for their reserves. The reserves provided backing for the currency and the country. They were a bank account that could be drawn upon in times of need. If oil prices shot up, a crop failed or lenders demanded their money back, there was a stockpile of money that could be used.
There was a longtime confidence in the dollar, even more when then-Chairman of the Federal Reserve Paul Volcker brought down inflation in the early '80s. The dollar was a good "store of value." And the fact that others were willing to hold American dollars was a big advantage to the United States-it could borrow cheaply abroad.
To assure the dollar's standing, by the '90s, America officially had a strong-dollar policy. Speeches by then-Secretary of the Treasury Robert Rubin affirmed our determination to maintain the value of the dollar. And for much of the period, the dollar was indeed "strong." But it had little to do with the speeches, though I sometimes suspect not only that the secretary of the treasury but also the financial markets thought so.
For the past eight years, the dollar has increasingly become less revered. Its value has been volatile. As the rest of the world saw the United States struggling with a failing war and soaring budget deficits, many who had large dollar holdings began to reduce those reserves (or increase them less than they otherwise would have). All this put downward pressure on the dollar. And thus began the first signs of a vicious circle. The strength of the dollar is becoming riskier and riskier. The growing U.S. deficit and the ballooning of the Federal Reserve's balance sheets leave many worried that in their wake will come inflation, undermining the long-term attractiveness of the U.S. currency.
In this article, I try to explain why the dollar is in trouble, but ask-should we care? What are the consequences? I will suggest that, for the most part, and for most Americans, it is probably a good thing. But the adjustment to a lower value of the dollar will not necessarily come easily. One of the consequences-already under way-is the fraying of the dollar-reserve system. I argue that a move to a global reserve system would be good for the United States, and good for the world.
OVER EIGHT short years, former-President George W. Bush doubled the U.S. national debt (with little to show for it, except a wrecked economy). With the debt expected to double again in the next decade (in optimistic scenarios), the picture gets grimmer still.
America's debt-to-GDP ratio is slated to increase from 40.8 percent in 2008 to 70 percent or more by 2019, and if interest rates return to more normal levels of say 5 to 6 percent from their current range of 0.0 to 0.25 percent, it will mean the cost of paying interest on the debt will eat up a substantial fraction of tax revenue (20 percent or more)-unless taxes are raised. The costs of funding programs for the aging baby boomers will only put further strains on the budget.
Granted, deficits by themselves need not present a problem. Deficits are of course only one side of a country's balance sheet. On the other side are assets. If a company borrows money to make high-return investments, no one is worried-so long as those investments do in fact yield returns.1 Our soaring deficit is not a concern if the money is spent on education, technology, infrastructure-all investments that historically have yielded very high returns, far higher than the interest rate the government has to pay-because then the returns to our society are far greater than the costs. But, if the money is spent on wars in Afghanistan or Iraq, poorly designed bailouts for banks or tax cuts for upper-income Americans, then there will be no asset corresponding to the increased liabilities, and then there is cause for concern. This seems to be the road we have been heading down for the last eight years and, disappointingly, are to too-large an extent continuing to travel.2
And with it there will be strong incentives to reduce the burden of the debt through inflation because inflation reduces the real value of what is owed. It means the government will pay back its debt with dollars that are worth less than they are today.3
This is how we come to another threat to the dollar: inflation.
THE STRENGTH of the dollar is determined by the laws of supply and demand, just like the value of any asset. The demand for a currency is based on the return to holding the asset relative to other assets, e.g., the interest rate received from a dollar asset, like a Treasury bill, plus the expected capital gain or loss. Demand today (and thus the value today) depends critically on expectations about the value tomorrow, but the value tomorrow will, in turn, depend on expectations of the day after. Prices are inexorably linked to expectations of the future, both near and far. If investors, or even people as a whole, believe that sometime in the future there is going to be high inflation, then those who hold dollars will be able to buy less with those dollars. The demand for dollars then-and now-will decrease, and hence (holding everything else constant) so will the value of the dollar at the present moment.
As market participants have watched the U.S. deficit rise dramatically and the Federal Reserve effectively print money seemingly without limit, fears of that very kind of inflation, not now, but sometime in the future, have grown. The fear is not of immediate inflation; there is so much excess capacity and unemployment that deflation is in fact more a worry. But the longer-term concern is that if and when the economy recovers, inflationary pressures will grow.
THE FEAR from some debt holders (China in particular) is that the U.S. government will purposely try to raise inflation-or be soft in resisting it, for the obvious reasons. I would normally think these concerns to be exaggerated. "Inflating" away debt is not painless. And if the Fed tried to do so, our foreign creditors would immediately demand higher interest rates-the only way to collect the real value of what they are owed.
The Fed, of course, right now wants to keep interest rates low because it is worried about the recovery. The only way to offset our foreign debt holders' demands of higher interest rates would be to start buying up our own debt (the same T-bills the Chinese buy) to ensure our interest rates stay low. But this would only make the Fed's balance sheet worse.
There is another reason that I would normally not be so worried about the buildup of the deficit and the Fed's ballooning balance sheet. It is in the genes of all central bankers, ours included, to fight inflation. It is part of their self-identity. But the situation now is unique, so the Fed might not be as "tough" on inflation as it would normally be. The Fed knows that it is largely responsible for having created the crisis. Like the arsonist who calls the fire department, it has now received kudos for helping put out the fire. In these circumstances, it especially doesn't want to be blamed for putting the economy back into recession, just as it is climbing out. That suggests that it may err on the side of caution as it contemplates whether to step on the brake now.
There lurks in this morass the possibility of another outcome that will not be good for America: the Fed will allow interest rates to rise somewhat-sufficient enough to stifle the inflation in the short run, but not enough to stifle our creditors' fears of future inflation. We will pay an "inflation premium," but not enjoy any benefits from the inflation that would normally reduce the real value of our national debt. Because we will have had to pay higher interest rates, in effect, inflationary expectations will have added to the real value of our national debt.
BUT OUR creditors will have to worry about another possibility as well. And it is equally threatening and probably more likely: the Federal Reserve will not intentionally attempt to hike up inflation, but its incompetence in managing monetary policy will do the same. In the best of circumstances and with the best expertise, monetary policy is difficult. It takes six to eighteen months for monetary policy to have its full effects. The Fed has to forecast where the economy is going, with considerable accuracy. Acting either too vigorously or too soon will plunge the economy back into recession. Delay may lead to an onslaught of inflation. Balancing the risks moment by moment is a Herculean task. Anyone looking at the Fed's record has to feel some anxiety. It repeatedly underestimated the severity of the problems leading up to our current crisis.4 And to make matters worse, we are in uncharted territory: no central bank has confronted a situation quite like ours.
The Fed is walking a policy tightrope. Many banks today have "excess liquidity," enabling them to lend, yet they choose not to because of fears they won't get paid back. We wish at this moment in time that they would lend more to get the economy moving again. The difficulty is that once the economy starts to strengthen and recover, that is precisely the time when our banks would decide to start lending more. And that is precisely when we want the banks to stop lending too freely, lest we stretch the economy to the limit once again. The additional lending would risk reinforcing inflationary pressures.
The standard policy prescription for these poorly timed loans is to, somehow, reduce banks' ability and willingness to lend when necessary. And the Fed says it will deftly do just that, for instance taking out this excess liquidity as needed, or paying interest on deposits in the Federal Reserve so that banks' incentives to lend will be weakened. But many, looking at the Fed's track record and its seemingly cloudy crystal ball, are unconvinced.
The most recent episode has shown that markets are often not self-correcting and central bankers don't always know best. Worries about inflation and the Fed's intentions and capabilities will continue to decrease the value of the dollar. The dollar is in trouble indeed.
WHY IS the future of the dollar so important? The global financial system has been called a dollar-reserve system, as countries use dollar reserves to enhance confidence in their state and their economy. But the dollar is no longer a good store of value. It provides risk without return. The yield on a T-bill today is around zero, and no one-not even the most confident supporter of the Fed-would say that it is without risk. It is thus understandable that countries which hold large amounts of dollar reserves are feeling anxious. They don't want to see their hard-earned savings disappear. And some of the moves countries will now take to protect themselves will both weaken the dollar and move the world away from the dollar-reserve system.
China's Premier Wen Jiabao has already forcibly expressed his concerns (which are widely shared within the country) about the long-term strength of the dollar, and while we have equally forcefully explained that he should have complete confidence in the dollar, most are unconvinced. And with China holding so much of our debt, the impact of its actions will be felt far and wide. Some small countries that can move much of their reserves out of dollars already have done so. Others are likely to follow suit-providing a further reason that the dollar may decrease in value.
Now, China and Japan face a distinct problem: if they sell too much of their reserves too quickly, the value of the dollar could fall dramatically, and that would undermine the value of their remaining dollar reserves. Moreover, it would make exporting to the United States more difficult. That has led some Americans to take comfort, thinking that China, caught between a rock and a hard place, has no choice but to continue with the current system. This is not correct. China does have strategies it can use, many of which make the future of the dollar perilous.
One tack, likely to be followed by Beijing to the extent that it can: continue to buy dollar assets, but look for investments that are somehow protected against inflation and exchange-rate fluctuations, or at least better protected than U.S. T-bills. An example of such an investment is U.S. inflation-indexed bonds (Treasury inflation-protected securities or TIPS). The value of these funds rises with inflation, so they appeal to those wary of being hit with rising prices. While that doesn't necessarily protect one fully against exchange-rate fluctuations, it at least protects against the correlated risk of inflation. This strategy maintains the strength of the dollar, and for those concerned about that issue, it is the tack they hope the Chinese take.5
There is a second tack that is already part of the Chinese strategy and undermines the likelihood the dollar will be kept as the reserve currency: shift the locus of sales. Some have suggested that China is dependent on exports to the United States. But that may be less true than some Americans believe. Formerly, there was the belief that the U.S. financial system and its monetary/fiscal policy were such that whatever was lent would be repaid, and with "sound" dollars. That confidence has now been eroded. Instead, Beijing could provide the finance that would enable Southeast Asians, Europeans or Africans to buy its goods-or even to allow the Chinese themselves to purchase the goods made in China. For when a country provides "vendor finance"-simultaneously selling the goods and financing the sales-it has more choices. The point of vendor finance is that one is not intending to give the goods away, but to get paid at a later date. For the repayment to be made in dollars of diminished value is akin to getting the merchandise at a big discount. Instead, providing funds to Africa and other mineral-resource-rich countries could yield double or triple dividends, including access to scarce resources and enhanced geopolitical influence, especially important at a time when the United States has its focus on other matters. In the end, this simply means the Chinese will buy fewer dollars and the value of the dollar will fall.
The final part of the response, and in some ways the most important for the long run, is a reform of the reserve system, through the creation of a global reserve system. For holders of reserves, this approach lends the prospect of efficient (low-cost) risk diversification. The notion that in this world of globalization, there would be so much dependence on a single country's currency seems anomalous, and especially so when that country has experienced such economic and political vicissitudes.
The key implication for the global financial system: the dollar will no longer be the reserve currency.
THE CURRENT system is unstable, leads to a weakened global economy and is unfair. It works to the disadvantage of developing countries, but also to the disadvantage of the United States. It is a system that produces only losers.
Developing countries have been putting aside hundreds of billions of dollars in low-yielding reserves instead of undertaking potentially high-yielding investments. Typically, developing countries should be borrowing and spending in order to grow. And this is good for the global economy as a whole. But, they are cautious because of what they saw happen during the East Asian crisis of 1997 when, without enough reserves, developing countries were unable to pay back the money they had borrowed from the West. And the economic policies foisted on them by the IMF and the U.S. Treasury not only led to what many perceived to be a loss of their economic sovereignty but also converted downturns into recessions, recessions into depressions. As the prime minister of one of the East Asian countries that suffered from the 1997 crisis confided in me, "We were in the class of 1997. We learned what happened when you didn't have enough reserves." Their response was the familiar: "Never again." Clearly, these developing countries realize the high opportunity costs of doing more saving than spending, but they are equally aware of the even-higher costs-both to the economy and to their societies-of not having large-enough reserves.
In the end, by building up reserves they enhanced their countries' economic security, but they also contributed to weakness in global aggregate demand. This is a problem that is likely to persist for years to come. So long as the global economic system is as volatile as it has been, and so long as there are not cheaper alternative ways of obtaining the requisite security, countries that can will put aside money into reserves.
In earlier days, profligate spending by developing countries helped offset the frugality of the better managed. But since those countries learned their lesson, America has become, in a sense, the "consumer of last resort."
John Maynard Keynes and Yale University's Robert Triffin pointed out that as countries around the world build up reserves in the currency of a single country, confidence in that reserve currency erodes. Reserves are just IOUs from the reserve country to the rest of the world. As America owes more and more money to others, those nations inevitably start to question whether they will be paid back-or be paid back with dollars that are worth anything. And there is a further political-economy problem: because reserve-currency countries can borrow so easily (other nations are willing to hold the country's IOUs even when the return is close to zero), the temptation to profligacy may be hard to resist. Certainly America hasn't been able to resist the temptation. Hence America's enormous fiscal deficit.
It is a basic economic identity that the trade deficit is equal to U.S. borrowing from abroad.6 If foreigners lend us more money (T-bills they put in their reserves), then we will have a larger trade deficit. Running a trade deficit means the United States has a high level of net imports. This, in turn, means people buy fewer domestically produced goods and national aggregate demand (which is simply the sum of consumption, investment, government expenditures and net exports) is weakened. Unless the country is going through a period of "irrational exuberance," leading for example to a tech bubble (the case of the United States in the 1990s), aggregate demand may be so weak that the economy will be operating below its potential. To combat this low demand and stimulate the economy, the government commonly runs a fiscal deficit-it spends beyond its income. This has the adverse effect of leading, in the long run, to less confidence in the reserve currency. Yet this is the course the United States has typically taken and seems intent on continuing. It is economically unhealthy and creates massive worldwide imbalances.
Over time, the fact that those countries that should have been spending (on investments) were lending, and those that should have been lending were borrowing, created an unsustainable system. In a bizarre way, this has created a kind of reverse foreign aid. Poor countries are lending to the United States trillions of dollars at a zero interest rate.
A GLOBAL reserve system could help address all of these problems. One way of thinking about this system is to think of a massive gold mine being discovered underneath the IMF. It yields, say, $600 billion a year. The IMF could simply ship out the gold to its members (say, in accordance with a particular formula based on their income). Now, instead of shipping the gold, the IMF issues pieces of paper telling each country how much gold they now own underneath the IMF building on 19th Street. Paper gold, we could call this. It's clear that we don't really need to have the gold. All that matters is trust, the willingness of governments to exchange the paper gold (Keynes called it bancor; one could call it global greenbacks) for their own currency-and that would be achieved through international agreement. In this situation, everyone has guaranteed reserves.
This would first and foremost help the problem of developing countries that have been hoarding their savings rather than investing. But by helping them, it would help the entire global economy-a new kind of trickle-up economics. They could each hold the paper gold in their reserves as a buffer against all of the risks they face. Consider a country that had been setting aside $50 billion a year in reserves, but now gets a transfer of $50 billion in paper gold, put into its account at the IMF or in a "New Global Reserve Facility" that might be created to administer the new global reserve system. Because their reserves are now sufficient to protect themselves against the global economic vicissitudes, they wouldn't have to put aside from their current incomes the corresponding amount. They could spend that amount, and that would lead to stronger global demand.
The system has one further advantage. Another basic economic identity is that the sum of trade surpluses must equal the sum of trade deficits; if some country exports more than it imports, some other must import more than it exports. So long as there are some countries that run surpluses (like China and, until recently, Japan), some other country must run deficits. But deficits are like hot potatoes. Countries with too-large deficits have learned the hard way what happens-there can easily be a run against the country's currency, leading to a currency and financial crisis. But if one state with too big a deficit takes actions to reduce it, the deficit just moves to another country. It was not an accident that after the East Asian governments reduced their trade deficits, deficits showed up in other parts of the world. As all tried to make reductions, the United States became the deficit of last resort-again an unsustainable situation. Under the global reserve system, with an annual emission of reserves from the new worldwide global reserve facility, countries could still run moderate deficits and let their own reserves build up. The system would be far more stable. And the system could be designed to incentivize countries not to have reserves, by, for instance, reducing allotments of new emissions to countries that ran persistent surpluses.
We already have a precursor to a global reserve system, in the IMF "money" called Special Drawing Rights (SDRS). The problem is that the issuances have been episodic, small and the money allocated in ways that are not ideal-America gets the largest allocation.
The UN Commission of Experts on Reforms of the International Monetary and Financial System (which I chaired) has argued that fixing the issuance of the SDRS is perhaps the most important medium-term reform that can be undertaken if we want to have a robust and stable recovery. The new global reserve system is not a panacea for the world's financial ills, but it could make the global financial system work far better than it has in the past.
SOME IN the United States are resisting the increasing demands for a global reserve system. The adverse effects on the United States (both as a result of heightened global instability and the associated trade deficit that are weakening national aggregate demand) are not always as obvious as the advantages of being able to borrow at a very low interest rate.
What does a weaker dollar really mean for Americans and the global financial system? A weaker dollar means America can export more-and will import less-and that is good for jobs. A stronger labor market leads to increased wages, and that too is good for workers. Export businesses gain, and so do those that compete with imports.
Certainly this will not be good news for everyone. Those who depend on imports-like retailers selling imported clothing-lose. Those on Wall Street who have bet on a strong dollar (and put their money in dollar bonds, say, relative to euro bonds or yen bonds) suffer. The weaker dollar may contribute a little bit to inflation, as the price of imports increases. If the Fed suffers from inflation paranoia, it may respond by increasing interest rates.
Like any major economic change, there are winners and losers. One can't always tell whether, on average, a particular change is good simply by measuring the volume of noise created by supporters and critics. Wall Street losers may be more voluble and visible than the many workers and main-street businesses that benefit.
But the current system is simply unsustainable no matter how many cries on Wall Street there are to the contrary. Countries will be more and more reluctant to lend to the United States at the favorable terms that they have in the past, while the disadvantages associated with global instability may be mounting. The United States cannot unilaterally declare the dollar the reserve currency. Others have to choose to accept the dollar in their reserves. America may not want to contemplate the possibility of losing its reserve-currency status, just as it's trying to figure out how to finance a $9 trillion ten-year deficit. But it may have no choice. Overall, a move away from the dollar-reserve system is inevitable-and, contrary to conventional wisdom, it will benefit the United States.
IN SHORT, the dollar-reserve system is already fraying. The question is, what will happen next? Economists are not good at predicting timing-when will all of this happen? And things don't always move smoothly. During the crisis, the dollar actually strengthened. With the U.S. government providing guarantees on money markets and other deposits-and a U.S. government guarantee having more credibility than that of many developing countries-money sought a safe haven. America, from where the crisis originated, seemed safer than those countries that were the innocent victims.
And the dollar may continue to be strong for some time because what is happening elsewhere could be worse: worries about inflation are also arising in other countries. There may be even less confidence in, say, Europe's ability to manage its affairs, and if so, the dollar may strengthen further, not because of confidence in the United States, but because of a lack of confidence in other markets. No wonder that, with all these uncertainties, almost the only thing we can be certain of is that markets will be marked with volatility.
As we move (hopefully) toward a global reserve currency, there will be inevitable bumps in the transition along the way. There are, of course, alternatives to the SDRS approach. We may create a multiple-exchange-rate system, in which countries diversify their reserve holdings between the dollar, euro and yen. Over the long run, this system could be highly unstable, as in one period the euro will appear stronger, and funds will shift there, weakening the dollar and strengthening the euro. In another, just the opposite may happen.
Or we may begin to form regional reserve systems. They also manage and dole out reserves for a group of countries but on a smaller scale (along the lines of the Chiang Mai Initiative in Asia, which has been greatly expanded during the crisis). Latin America is discussing doing something similar. One of the ways of creating the global reserve system is through developing and then interlinking these regional efforts.
Whichever path we take, like it or not, we will be moving away from current arrangements, the dollar-reserve system. There are only two questions: will the movement away be orderly or disorderly, and will America play a part in shaping the new system that will emerge? I believe that the transition to the new system will be smoother and that both the United States and the world will benefit if we stop putting our heads in the sand and help create the worldwide reserve system that the globalization of financial markets requires. Keynes recognized the need for such a global reserve currency seventy-five years ago. At the Bretton Woods meeting of 1944, in a costly act of self-interest, the United States blocked the full implementation of Keynes's scheme. This is an old idea whose time has finally come.
Joseph E. Stiglitz is University Professor at Columbia University. He served as chief economist of the World Bank from 1997 to 2000. Most recently he is the author, with Linda J. Bilmes of Harvard's Kennedy School, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict (W. W. Norton, 2008).
1 Our wizards of Wall Street got it all wrong: they seemed unfazed when household debt mounted, pointing out that there was something to show for it, a house whose value well exceeded the debt. But they had helped engineer a bubble, and the true value of the assets was in fact less than what was owed. The result is the economic travails that we are now going through. At this point, many are upset as they see the government's deficit soar-and they pay no attention to whether there are any assets corresponding to these liabilities.
2 Wall Street deficit hawks went on vacation from September 15, 2008, to mid-2009, while the money was pouring into the banks. But as soon as it became clear that there was no more money for the banks, they went back to their usual stance.
3 It is also a way of handling the problem of excessive household indebtedness, and creditors certainly don't like this prospect.
4 It didn't see the bubble-even claiming there was no bubble. When the subprime bubble broke, the Fed claimed the problems were contained and limited. Just months before the calamitous events of fall 2008, it was claiming, privately and publicly, that we had turned the corner.
5 It is unlikely they will try to get around their fears of inflation by buying real assets like real estate or shares in companies. The losses that China experienced on its Blackstone investments (Beijing bought a $3 billion stake in the company) have provided a cautionary note. And will America take well to China buying key assets? It's one thing to take a loser-like the Hummer-off our hands; it's quite another to sell an asset like UNOCAL.
6 What ensures that it is true is more complicated. It can be adjustments in income or in exchange rates. When the exchange rate (the value of the dollar relative to the euro and other currencies) increases, we export more and import less. When our income increases, we import more.