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.Essay Types: Essay