An Unstable Dollar Standard

We live in a period of world-wide economic expansion and prosperity. The world economy is said to grow this year at some five percent, which will be the third year above the historic average. Even if, in the coming year, the growth rate should decline a little, the global economy looks bright and prosperous. Led by some Asiatic countries, especially China and Japan, more countries than ever before are reporting rapid economic expansion.

But no matter how bright the economic outlook may be, the international prosperity is exposed to a looming risk, which has even grown in recent months. The war in Iraq and the skirmishes in Afghanistan are an ever-present danger that may destabilize the Middle East and spread the conflict to more countries. The Islamic republic of Iran, which does not hesitate to confront American interests and concerns, may upend the peace at any time. But the greatest concern of many economists is the global economic imbalance which is clearly visible in the huge balance-of-payments deficits of the United States and in the corresponding surpluses of the creditor countries. Americans are said to consume some 70 percent of the world’s savings while Japan, China, and other developing countries are financing the deficits and accumulating American IOUs. Many economists are convinced that such disproportions and imbalances are unsustainable in the long run.

Surely, American foreign debt has increased significantly, but so has individual income and wealth. Total domestic debt has risen visibly over the last decade, but so have productivity and income. This economic harmony nevertheless is burdened by considerable risk of global imbalances that may cause disruption and upheaval in the future. The debt-and-credit differences of the large national economies continue to grow, the balance-of-payment deficits of the United States surpass all national surpluses. In 2005 the deficits amounted to some $790 billion, which, in relation to gross national product, exceeded six percent. So far this year, it may exceed $800 billion, or 6.5 percent of GDP. Moreover, the federal government continues to suffer huge budget deficits which enlarge the national debt and add weight to the international concern.

The American mountain of debt is matched by large balance-of-payment surpluses in developing Asian countries, as well as by most oil-exporting countries. Many creditors welcome the surpluses. They keep the exchange rates of their currencies low which, in turn, boosts their exports and gives employment to millions of workers who, with American assistance and technology, are learning to produce for the world market. Chinese banks now hold nearly $1 trillion, which is the highest reserve position in the world, having passed Japan this year with some $865 billion. Without such dollar purchases, their currencies would rise immediately, which would boost all export prices, curb exports, and depress economic production and employment.

A few critics believe that the U.S. trade deficits may be the greatest threat to the economic order. Yet the deficits have neither impaired the U.S. dollar nor undermined the position of the United States as the primary economic engine and power. Many observers, therefore, question and disclaim the dangers of American balance-of-payments deficits. They not only cast doubt on official statistics that may exaggerate the case, but also point to the stable rates of exchange which all participants maintain voluntarily. Stability, after all, benefits everyone.

This economist, nevertheless, is convinced that a correction is unavoidable. All markets function to adjust and readjust any maladjustment. They are burdened and strained by the growing mountain of debt which raises the question of American ability to meet its obligations. If there ever should be any doubt about the stability of the American economy, the world-wide demand for U.S. dollars would decline, which would cause the dollar exchange rate to plummet. American imports would decline, dampening the surge of consumption and slowing the very growth engines of export countries such as Japan, China, and many others. The whole world would feel the American instability. A weaker dollar and rising import prices also would accelerate the inflation rate which would pressure the Federal Reserve to raise interest rates. Higher rates would slow the American economy and boost the rate of unemployment.

Despite such international imbalances, the U.S. dollar has not weakened significantly in recent months, and the world economy has not fallen into a global recession. At first, Asian central banks, and then also the oil-exporting countries, financed the huge deficits. It is in the economic interest of the Asian developing countries to keep their exchange rates low in order to keep export prices low and thus keep the export motor running. Massive purchases of federal obligations support the exchange rate of the dollar and increase Asian currency reserves.

It is in the interest of the United States, as well as the Asian countries, that the U.S. dollar maintain its high exchange value. Some American economists like to speak of a “Bretton Woods II” arrangement, which would resemble the international system in effect between the Second World War and 1973. Participating countries supported each other’s currencies and thus sustained stable exchange rates.

In Bretton Woods I, the member countries supported each other’s currencies – in Bretton Woods II, they eagerly support the dollar. The European Central Bank, which actively pursues employment policies, manages to avoid the influx of U.S. dollars by keeping interest rates very low and liquidity plentiful. According to some estimates, the quantity of money in euro countries, since 2000, has increased some 25 percent faster than the gross product. In the United States, it has grown some 10 percent, and in Japan by 15 percent. The European Central Bank even surpassed the Bank of Japan, which is inflating its currency in order to counter powerful deflationary forces. In short, euro liquidity is plentiful and interest rates, seen historically, are exceptionally low.

As the U.S.-Asian imbalances continue to mount, the forces of readjustment are gaining strength. There are indications that the imbalances are correcting slowly and in an orderly fashion. Most governments agree that greater flexibility of the exchange rates, especially of the Asian currencies, is an orderly step toward the correction of the global imbalances. But most governments cling to their old policies. The interest rate differences are closing slowly, which causes more and more investors to shun the dollar risk. Moreover, the American real estate market has cooled off significantly without dramatic crashes. The boom, according to Fed Chairman Ben Bernanke, has given way in an orderly and moderate fashion. But there cannot be any doubt that the decline in the housing market will be felt throughout the economy in months to come.

Some Americans will have to curtail their spending which is bound to slow down the economy. Will it drag the world economy with it? The rate of expansion in many Asian countries undoubtedly will decline, but by less than pessimists predict. Most economic expansion in China, India, and other developing countries in recent years has been driven by domestic demand and supply. Yet we must not underestimate the weighty and consequential role played by the United States in world financial markets. A huge debt casts a shadow on any market; the rapidly growing international debt of the United States is clouding the world economy. It cannot grow perpetually; it will be settled sooner or later either in an orderly and upright fashion or in financial crisis and economic recession.

The finale of the scenario may be played by the Federal Reserve System. It may seek to reassure and pacify numerous Asian creditors by maintaining high market rates of interest or at least approximate them, or cater to the notions and wishes of most legislators and their constituents who usually favor monetary stimulation. Sooner or later Federal Reserve governors will have to choose between economic consideration or political preference. Their choice will determine the future of the U. S. dollar.

Hans F. Sennholz

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