The Dollar and the Deficits

by C. Fred Bergsten

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 will accelerate the prospect that foreign central banks will switch to euros, Special Drawing Rights at the International Monetary Fund, or even commodities and other "real" assets. There is plenty of ammunition to fuel the attacks, with over $20 trillion in dollar instruments held outside the United States and much more held by Americans themselves.

The common cause of these attacks on the dollar is the prospect of U.S. 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.

Perhaps most important, such massive budget deficits would almost certainly produce massive trade and current account deficits. When the United States recovers from the current crisis, the enormous government spending on top of normal private consumption and investment, 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 U.S. foreign debt.

My colleague William Cline has projected that, with the present budget outlook, the U.S. 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 United States, which already exceeds $3 trillion, would reach $15 trillion by 2020. The expected doubling of the ratio of U.S. government debt to GDP, to a level far beyond any prior U.S. peacetime experience, would be matched by a doubling of its foreign debt to GDP ratio and take it far beyond the threshold that normally triggers currency crises and forces painful economic retrenchment. The United States would become even more perilously beholden to China, Japan, Russia, Saudi Arabia, and other foreign creditors.

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 the United States does not. If the rest of the world proved unwilling to finance the U.S. deficits, the dollar would fall sharply and perhaps crash. U.S. 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. The dollar would lose much of its remaining international status.

If the foreigners did finance U.S. 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. Unless 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 United States whether or not they can be funded by international investors.

The United States does need a modest further decline in the dollar, mainly against the Chinese renminbi and other Asian currencies, to restore its full price competitiveness in world trade and to sustain the decline in the current account deficit that has accompanied the recession. It should welcome a modest and orderly decline in the international role of the dollar--which is inevitable anyway due to the growing dispersion of economic and financial power around the globe--because the "automatic financing" through which it encourages U.S. external deficits is no longer in the national interest. The United States should in fact set a national policy goal of limiting its current account deficits to a maximum of three percent of GDP, which would keep U.S. foreign debt from rising any further as a share of the real economy.

The United States must get its 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 its foreign deficits and debt soar once again. Premature tightening, however, could choke off the fragile recovery. Washington thus needs to make budget decisions in the near future, to be phased in over the next several years as the economy returns to normal, which would come 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 reindexing 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 correctly emphasized the need to rebalance the world economy and the shape of the United States' own recovery, rejecting a return to the large trade deficits that have come with its being the "consumer of last resort." It has made little effort, however, to enact domestic policies that would do so. Credible and lasting correction of the budget deficit is essential to protect the dollar against further attacks on its international value and its continuing vital role in the global monetary system.

Economy: The Dollar and the Deficits - C. Fred Bergsten