U.S. Debt Culture and the Dollar's Fate
Mini Teaser: If the United States cannot get its fiscal house in order, the dollar’s privileged position as the world’s reserve currency may be at risk—at a time when there seem to be few if any plausible alternatives.
Through the 1970s and 1980s, as core industries were stripped out of the United States and moved offshore, lost jobs were replaced with domestic-oriented service industries. Chief among these was housing, a necessary and popular area of economic activity that supports employment but does not create any national wealth. The first surge in real-estate prices, which was again driven by the demographic force of the baby boom, ended with the savings-and-loan crisis of the late 1980s. Several of the largest U.S. banks tottered on the brink of failure in the early 1990s. But these crises only presaged the subprime meltdown of the 2000s.
As domestic growth slowed and inflation reared its ugly head, Americans for the first time since the years following World War II began to feel constrained by debt and a lack of opportunity. But instead of succumbing to the constraints of current income, Americans substituted ever-increasing amounts of debt in order to maintain national living standards. Through the 1990s and 2000s, the United States used a toxic combination of debt and easy-money policy to maintain growth levels while a politically cowed, “independent” central bank pushed interest rates lower and lower to pursue the twin goals of full employment and price stability. Under Chairman Alan Greenspan, the Fed kept the party going in terms of nominal growth, even if American consumers actually lost ground in terms of wages and inflation, proof that the Fed’s dual mandate to foster both employment and stable prices is impossibly conflicted.
The use of debt to bid up the prices of residential real estate from the late 1990s through 2007 is yet another example of the determinative impact of demographics on the economic narrative. Federal spending financed with debt started to grow dramatically in the 1980s, while mandates for future social-welfare benefits likewise began to soar. Domestic industries continued to lose ground to imports, which were encouraged through now-institutionalized free-trade policies to preserve the myth of low domestic inflation for consumers.
As the debt dependence of the United States grew from the 1980s onward, the rest of the world benefited from the steady demand for goods and services needed to satiate American consumers. So long as America was willing to incur debt to buy foreign goods, the global financial system functioned via a transfer of wealth from the now-developed U.S. economy to the less developed nations of the world. And to a large extent, the model worked. Today, India, Mexico and Brazil have all repaid their once-problematic foreign debts, leaving agencies such as the World Bank and IMF seemingly out of a job. The question remains how to turn the success of the new world as an export-oriented platform into a stable, competitive marketplace among global industries and nations.
IN A December 2011 comment in Project Syndicate, Mohamed El-Erian of PIMCO wrote:
A new economic order is taking shape before our eyes, and it is one that includes accelerated convergence between the old Western powers and the emerging world’s major new players. But the forces driving this convergence have little to do with what generations of economists envisaged when they pointed out the inadequacy of the old order; and these forces’ implications may be equally unsettling.
El-Erian points to a most troubling aspect of considering the state of the Old Order in global finance—namely, that much of it was a function of war, demographics and other factors far removed from the minds of today’s world leaders. Whereas after World War II there was a strong international consensus behind coordinated government planning when it came to global finance, today the resurgence of neoliberal thinking makes such concerted action unlikely. At the time of Bretton Woods, respected icons of the Old Order like Henry Morgenthau called publicly for government control of the financial markets; today, such views would be ridiculed as retrograde.
Yet even now, the blessed age of globalization—including support for free markets and free trade—may be receding after decades of torrid economic expansion around the globe driven by easy money and debt. “The aging of the baby boom will redirect spending toward domestically provided services and away from foreign supplied gadgetry,” one senior U.S. official said in comments for this article. “The same is true in other industrial countries. Export-led growth is overrated.”
With the subprime-mortgage crisis in the United States since 2007 and the subsequent collapse of the EU nations into a financial meltdown, the dollar remains the only currency in the world that investors trust as a means of exchange, despite America’s massive public debt. Even though the Old Order built around the dollar is in the process of disintegrating, there is simply no obvious alternative to the greenback as a means of exchange in the global economy, at least for now. As my friend and mentor David Kotok of Cumberland Advisors likes to say, “Being the reserve currency is not a job you ask for. It finds you.”
In any event, asking whether the dollar will remain the global reserve currency may be the wrong question. In practical terms, neither the euro nor any other currency is large enough to handle even a small fraction of global payments. The global energy market, for example, is too large for any currency other than the dollar to handle.
Furthermore, there are strong political reasons for the dollar’s preeminence. Far more solvent but also authoritarian nations such as Russia and China just don’t have the right combination of attributes to make their currencies a globally accepted means of exchange, much less a store of value. This fact still makes America the most attractive venue in the world for global commerce—and, yes, capital flight, albeit not a long-term store of value. But in order for the dollar to retain this privileged position, a great deal depends upon the United States turning away from years of ever-expanding government, ever-expanding debt and an ever-expanding money supply.
One of the great fallacies after World War II was that government needed to continue spending and borrowing in order to save the Allies from economic disaster, an offshoot of the Keynesian line of reasoning regarding state intervention in the economy. While choosing to rebuild the productive capacity of the world’s industrial states following the war was clearly the right policy up to a point, the resulting governmental expansion in all aspects of the U.S. domestic economy has sapped the long-term prospects of the world’s greatest market—and hence the global financial system.
Now the price has come due. Keynes and the other leading thinkers of the post–World War II era championed this leading role of government in economic affairs, but all ignored the fundamental truth that production and purchasing power are two entirely different things. Keynes believed, falsely, that purchasing power had to be kept high via government spending to support real production. But, as American economist Benjamin M. Anderson noted, “The prevailing view among economists . . . has long been that purchasing power grows out of production.”
Jobs created via productive economic activity increase the overall pool of wealth, but artificially augmenting consumer activity via government spending or monetary expansion merely slices the existing economic pie into ever-smaller pieces. Governments can use fiscal and monetary policy to encourage growth on the margins, but substituting debt-fueled public-sector spending or easy-money policies for basic economic activity is dishonest politically and madness in economic terms. Yet this is precisely the path championed by Keynes and recommended by most economists today. “We do not have to keep pouring more money into the spending stream through endless Government deficits,” argued economist and writer Henry Hazlitt in a 1945 editorial in the New York Times. “That is not the way to sound prosperity, but the way to uncontrolled inflation.” After living through almost a century of Keynesian-fueled boom and bust, the admonition of Hazlitt and other members of the free-market school is one that we would do well to heed today.
But it won’t be easy. As Friedrich Hayek wrote on this subject:
I do not think it an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order. A good money, like good law, must operate without regard to the effects that decisions of the issuer will have on known groups or individuals. A benevolent dictator might conceivably disregard these effects; no democratic government dependent on a number of special interests can possibly do so.
Hayek’s observation really gets to the fundamental issue facing Americans—namely, that changing course after almost seven decades of economic indulgence following WWII will be a domestic political challenge of the first order. Limiting public spending and monetary policy may ultimately force a political change in America in much the same way that Germany is now imposing fiscal austerity on the peripheral states of the EU via entirely nondemocratic means.
IF AMERICA can restrain its libertine impulses and get its fiscal house in order, the reality of an open, free-market, democratic system will continue to make the dollar among the most desirable asset classes in the world. But perhaps the real question is whether America will remain a free, open and democratic society in an environment of lower economic growth and expectations. After seven decades of using debt and inflation to pull future jobs and growth into the present, the prospect of less opportunity raises the specter of domestic political turmoil in the United States and other nations. Internationally, the result could be turmoil and war. This is not merely a short-run political challenge for Washington but ultimately threatens to challenge the self-image of American society. How will Americans react to seeing their children facing declining prospects for employment and home ownership?Image: Pullquote: The reason that the dollar is the currency of choice in the free world is because of the American political system, not just economic or foreign-policy considerations.Essay Types: Essay