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Can the World Avert a U.S. Dollar Crisis?

6 October 2009

by Daniel Michaeli

The value of the dollar has taken a hit as rumors spread that oil producers are exploring a scheme to price oil in a basket of currencies instead of the U.S. dollar. (The Wall Street Journal subsequently reported that Gulf officials “strongly denied” the rumors.)

This week’s news follows a year in which more and more banks and foreign governments have voiced concern that the U.S. dollar will weaken in the coming years. This has been discussed most openly in Asia, where China and Japan’s massive foreign exchange reserves are at risk.

But should demand for the dollar fall significantly, it is the United States that would suffer most. The U.S. could face a crippling debt crisis unlike any previous economic crisis we have faced in the last two centuries.

The massive national debt is, in effect, a kind of gigantic subprime crisis in waiting. The world’s willingness to purchase treasury bills has encouraged the government to buy more than it can afford, under the expectation that somehow, some day in the future, the government will be able to pay down its loans with future earnings. In the meantime, the U.S. takes out new loans to pay down old ones–at very favorable rates.

Recently, important American voices in global economics have expressed concerns about the direction of the dollar, which has serious implications for the U.S. ability to borrow money from abroad. Two of these are World Bank president Robert Zoellick in a speech at SAIS last week, and Nobel Laureate economist Joseph Stiglitz in an op-ed published in the Washington Post back in August. The United States cannot afford to ignore these voices.

Of course, there are compelling reasons to believe the dollar could remain strong well in the future. The U.S. dollar held strong during this crisis so far; indeed, when the global economy was at its recent nadir, investors seemed to believe loaning money to the U.S. government was safer than most other investments.

Still, there are also very serious reasons to be concerned. American and Asian policymakers must plan ahead, and work together, to avoid a severe crisis in the long term.

How the dollar looks today

Global demand for the U.S. dollar, and for the stability and reliability of U.S. treasury bills, are what have allowed the United States to issue new debt at will–and therefore to spend well beyond our means.

Spending money we do not have is a long-standing habit that has become strikingly worse in the past quarter-century. While the U.S. has been running federal budget deficits most years since the 1930s, these deficits have grown wildly out of control since the early 1980s. And it was in the 1980s that Japan and China, among others, discovered that by buying U.S. government debt, they could maneuver to increase the dollar’s strength relative to their own currencies. This made their exports more competitive and even more profitable.

The result was a dangerous global spiral, one that is far from over.

Weakness of American exports have combined with the U.S. government’s fiscal deficits to cause a spiral that is likely to continue for some time even after this financial crisis. The negative contribution of trade to America’s GDP leads the U.S. government to increase its spending to keep the economy growing. And in doing so, the U.S. issues more debt, which more countries buy, which strengthens the dollar even more–which makes U.S. exports even less competitive around the world.

The global financial crisis since 2007 has underscored two things for the world’s rising economies:

  1. For now, investing in U.S. treasury bills remains the safest and most stable investment for foreign exchange reserves and sovereign wealth funds; and
  2. Their countries, especially those that hold large quantities of U.S. debt, rely on the value of the dollar to an uncomfortable degree.

In particular, China’s apparent strong rebound from this crisis left Chinese leaders wondering why China’s foreign exchange reserves need to be quite so dependent on U.S. economic fortunes, when its economy has proven independently resilient in other areas. This March, China’s central bank chief proposed making an international basket of currencies the global reserve currency to reduce China’s dependence on the strength of the dollar.

Last month’s $879 million borrowing experiment by the Chinese government is noteworthy: China has begun issuing bonds denominated in renminbi, which they will repay in renminbi. There is little doubt that investors will be interested. Buying these bonds helps investors and central banks diversify away from the dollar, and they will earn higher returns since the renminbi is likely to appreciate.

Bob Zoellick of the World Bank predicted last Monday that the Chinese renminbi would become a force in financial markets and pointed to the euro as another strong contender for future currency reserves. As Chinese and European domestic markets grow, buying sovereign debt from China and the EU could become a useful tool for central banks as well as a hedge against the dollar.

But if a significant reduction in demand for U.S. treasury bills results, that would be catastrophic for the United States. The U.S. is depending on borrowing from the rest of the world to get out of its economic slump. The U.S. national debt is already nearly $12 trillion, will reach $13 trillion before the end of 2010, and will nearly double to $23 trillion by 2019, according to projections from the Obama administration.

Xinhua, China’s official news agency, remarked that even $13 trillion is “an almost unimaginable number that is bigger than every country’s annual GDP except that of the United States.”

A dollar currency crisis

As new powers rise in this increasingly multipolar world, the status quo is not sustainable forever. As China and others become more assertive members of global fora like the G-20 and the IMF, and the viability of ballooning U.S. national debt is called into question, investors will begin demanding higher yields on dollar debt to guard against the possibility of inflation and a weaker dollar.

The presence of alternatives like the euro, the renminbi, a currency basket, or–unlikely as it may be–a unified Asian currency (a favorite idea of Japan’s new prime minister) will make it impossible for the U.S. to continue refinancing its massive subprime loans, at least in this quantity, with U.S. dollars at affordable yields.

Losing the ability to borrow money in its current astronomical quantities means the United States will face very difficult choices in the future, depending on the nature of the crisis.

The only similar American crisis that comes to mind is the 1893 U.S. economic crisis that ended with J.P. Morgan’s 1895 bailout of the U.S. treasury. J.P. Morgan infused $62 million into the treasury, about 3.7% of the U.S. national debt at that time, to reassure investors that the U.S. would continue to pay back its debt. But a similar bailout seems unlikely today, when the countries that would have enough resources for a bailout are the very investors in need of reassurance. (These countries would need to sign on to any potential IMF bailout, too.)

America’s government could not declare itself bankrupt and default on debt without shattering the global economy. The simpler option would be to print more dollars, a unique privilege we have when paying down debt in a currency we ourselves control.

However, as a solution to an acute crisis, this approach is also a recipe for disaster. It would wreak havoc in the United States, where prices would shoot through the roof and retirement savings would become worthless as billions of dollars flood the economy. Investors could refuse to continue lending to the U.S., and as the value of the dollar tanks, imports–including energy imports–would very rapidly become too expensive for Americans to afford.

What if the crisis were more drawn out? What if, for example, central banks and sovereign wealth funds of countries like China, Japan, the United Kingdom, Saudi Arabia, and Brazil began slowly expecting higher yields on U.S. treasury bills?

That scenario is easy to imagine, particularly if more lucrative sovereign bonds are coming from new places–perhaps the European Union, China, or Brazil, for instance. When no country wants to make a move that will cause a rapid decline in the dollar’s value, then–rather than selling dollars, which would surely cause just that–asking for higher yields seems like a good bet.

In this case, with foreign investors expecting higher yields, it may be tempting to print more dollars slowly to reduce the apparent budgetary cost of interest payments. But doing so would start a dangerous spiral, as foreign investors demand ever higher yields. The higher the yields, the harder it will be in the future for the United States to work its way out of debt.

With annual interest payments on debt already nearing half a trillion dollars a year, the U.S. government would need to devote that much money to paying down debt each year just to keep the debt from growing even larger.

Printing money in an attempt to stem the problem would reduce the growth of the U.S. economy and result in sharply higher interest payments as investors respond to the inflation. Any apparent benefit to this approach would be very short lived.

Perhaps the most difficult option of all would be drastically cutting the federal budget and devoting a large portion of government revenues to paying down debt. Paying interest to avoid growing the size of the debt in 2008 would have required the U.S. to cut its budget by more than 30%, not counting the costs of slower economic growth and reduced government spending.

Another way to maintain the same level of government spending without increasing our debt last year would have been to increase taxes by $900 billion, or about $6,000 per taxpayer.

These figures are scary. Cutting the budget by 30% or taking $900 billion out of the U.S. economy would have tremendously negative consequences. GDP would drop and the United States would become less competitive around the world.

But if we do nothing now, this problem will only get worse.

Piecing together a global solution

Reducing spending and increasing taxes are necessary, but America will also need to work hard to export more, import less, or both. Growing our exports will require an aggressive approach to trade liberalization, and the cooperation of the rising economic powers. As a forthcoming report from the Council on Foreign Relations will argue, the trajectory of economic integration within ASEAN Plus Three is a threat to U.S. companies unless the United States Congress passes the United States-Korea free trade agreement and actively seeks other bilateral and multilateral trade agreements within the Asia-Pacific region.

U.S. exporters are disadvantaged not only because of trade barriers but because of distorted currency exchange rates.

To realign the global economic system for truly sustainable global growth, the dollar will have to depreciate relative to other currencies, and holders of U.S. treasury bills will have to agree to hold their dollar holdings even as they decline in value, until the U.S. pays down much of its national debt. This is not an unfair request: after all, as the U.S. government has borrowed more and more, many other countries encouraged this and their citizens benefited when they produced exports for the U.S. market. Most importantly, the global economic cost of many countries letting go of treasury bills would be far too high.

Depreciation of the dollar needs to happen as a result of natural processes of growth elsewhere–for example, when China allows the renminbi to appreciate–rather than because of inflation in the United States. The rest of the world has to be amenable to creative solutions to paying down U.S. debt, because no one benefits if the U.S. is left with no alternative than to spur inflation.

Boosting domestic consumption in the exporting countries with the largest trade surpluses–China, Germany, and Japan–will make a large difference in exchange rates and will increase demand for U.S. exports. Those three countries alone exported nearly $850 billion more than they imported last year.

Germany and Japan seem disinclined to make the kinds of reforms that the United States will need in order to rebalance its economy and pay down its national debt. But in both cases, particularly that of Japan, an aging population should dampen the luster of export industries and shift spending patterns towards greater domestic consumption.

China has the largest trade surplus of all, almost $400 billion in 2007. Private consumption in China contributed just 33% to China’s GDP in 2007 (versus around 70% in the United States). But even after this economic crisis, it is not clear that China is willing or ready to readjust.

The stimulus that has increased China’s domestic spending over the past year is a temporary one, and it includes a large rebuilding effort after the 2008 Sichuan earthquake. In some estimations, such as that of Stephen Roach, Morgan Stanley’s Asia chairman, China is simply biding its time before it can resume its export-oriented growth strategy.

Further, it appears that much of the emphasis by economists on increasing Chinese domestic consumption should be placed on the inefficiency of Chinese corporate profits–something less easily made into a sound byte, but still crucial. More and more corporate profits are hoarded away in savings instead of being pumped back into the economy. So even though household consumption has actually risen, total private consumption has declined.

China’s credit and tax incentives to heavy industry, and artificially low prices on land and energy, leave the services sector and small businesses at a great disadvantage. But it is those sectors that create jobs more efficiently; higher growth in those sectors would put more money into the pockets of workers and lift the role of consumption in the Chinese economy. Liberalizing the financial sector, so that loans are extended to those that can use it most efficiently, would boost China’s domestic consumption.

In turn, the renminbi would strengthen against the dollar, American exports would grow, and China’s trade surplus would be reduced.

Looking ahead

During the transitional process, it will be vital for the greatest holders of U.S. dollar debt to pursue complementary currency-related policies, in order to avoid panic and prevent any individual country from divesting of its dollar assets suddenly in order to protect itself, an action that could initiate a catastrophic cascade.

The United States, China, Japan, and Germany, as well as other major holders of U.S. treasury bills such as the United Kingdom, major oil exporters, Brazil, and Russia should communicate regularly with with one another on important economic policies that affect the value of the dollar. The G-20 could provide a framework for such regular communication. Topics of discussion would include budgetary planning, U.S. treasury bill issuances and purchases, financial liberalization efforts, and trade policy. Each policy area, if carefully managed and coordinated, can greatly mitigate the impact of market surprises and increase the chance that global rebalancing will proceed relatively smoothly.

If the United States, China, Japan, and Germany take the right transitional steps, the U.S. trade deficit can shrink and American GDP growth from exports will simultaneously make up for reduced government spending and contribute to government revenues. The U.S. will need to borrow less from abroad as more dollars are put to productive use within the United States and a substantial portion of the federal budget is devoted to paying down debt.

A reasonable way of reducing the national debt in the long term is the combination proposed above: a rebalancing of global consumption, trade liberalization, willingness by central banks to hold on to U.S. treasury bills even as they decline in value, substantial budget cuts, and tax increases. Each of these measures has merit in and of itself, but the absence of any component of this package could result in a failure to fix the massive global imbalance we face.

Still, it would be foolhardy not to expect that these policy moves will be politically costly for foreign leaders and U.S. politicians alike. While foreign leaders will be asked by their citizens why their government is holding so many dollars while the dollar weakens, U.S. politicians will be asked very tough questions about why government spending needs to be cut and why taxes must be raised–and they will run the risk of being kicked out of office.

Leaders are going to need to prepare very good answers to these questions.

The short answer to the first question is: the long-term economic prosperity of every country, including new rising economic powers, depends on a gradual realignment of the global economic system. Any major sudden policy moves that hurt the United States will have massive implications in the rest of the world; coordinated and gradual moves can benefit us all.

The short answer to the second question is: as the U.S. subprime mortgage crisis taught us, bad debt is a problem that only grows worse over time. Taking out new loans to pay down old ones is an unsustainable strategy. There is a proverb that asks: “If not now, when?”

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  • Kevin Slaten said:

    A clear-minded post, Dan. Good stuff. And although I agree with most of what you say, I would put a twist on your proposed solution(s). You say, "Still, it would be foolhardy not to expect that these policy moves will be politically costly for foreign leaders and U.S. politicians alike… Leaders are going to need to prepare very good answers to these questions."

    I think that even the most brilliant "answers" to the aforementioned questions will be insufficient. Democratic politics are, by and large, local. Consequently, convincing these electorates to vote the long-term seems unrealistic based on most every past election (as evidence).

    So my "twist" is this: lock all of the economies into an agreement now. Your G20 proposal is a good one. Focus on this approach. Foreign policy has the potential to be more long-term than domestic politics, so let the chief executives sign the deal. Sure, politicians should be ready to answer the questions, but once the agreement (that countries are going to take steps to shift the global economy gradually) is signed, then it becomes more difficult to back out (e.g. NAFTA).

    So the twist is, perhaps, just a refocusing. Focus on the international agreement.

    Of course, the prime ministers or presidents who sign these might be taking a one-time big risk that may damage them or their party domestically. But at such a moment that this agreement is written and waiting to be signed, it will be a (potential) major moment in history. A moment in which legacy is made. For if these individual leaders can muster the courage to risk sacrificing their political reputation, then they will have saved the world and its people a lot of pain.

    Ultimately, it will take a confluence of courageous people in power. We will see.

  • Walter said:


    Yesterday at work someone showed me a copy of the Economist whose cover story warned that the US dollar was headed for collapse. It cited that our debt was enormous and could be paid only after great inflation. It reported that nations were considering denominating oil sales in other currencies. It was from 1995.

    I think it's interesting to consider the circumstances
    that would lead to the dollar no longer serving as the reserve
    currency, and for a lot of parties involved, it seems to make sense to
    get out of dollars. But I think we learned something really important
    on September 15, 2008. When there was more fear than ever before in
    financial markets, we saw that investors rushed into canned foods,
    bullets, and US treasuries. It's still the safest currency in the
    world, which is precisely the problem for Americans: maybe we borrow
    so much money because we can do it so easily. We don't have to pay
    interest these days.

  • Walter said:

    We will come to remember the 90s as, to quote Fareed, "the rise of the rest.' With regard to trade imbalances, we will remember the last few decades, from the Robert Rubin's strong dollar policy ("A strong dollar is in the US National interest" as a departure from Lloyd Bensten's famous threat that if the Japanese don't make trade concessions we would inflate the dollar) to the subprime crisis, as part of a bigger trend. It's a global feedback loop that works like this:

    Low US interest rates encourage capital to flow into the emerging economies of the world (China, sure, but everywhere else too). As the nations invest this capital into a productive capacity, they have a problem. They are receiving a lot of USD and they are trying hard to export goods with their new manufacturing capacity. Both of these forces push their currency upward. But most of these emerging economies (china, vietnam, brazil, russia, indonesia, india) control their currencies. they hold it down. But to hold it down, they will send capital out (they won't consume), buying US treasuries. Higher demand for treasuries keeps US interest rates low.

    This cycle leaves global interest rates too low. This is a fancy way of saying that people everywhere (because of government manipulation in some cases) are too willing to save and invest in low returns. It becomes really hard to find yield and we make mad investments on large scales.

    (1) there is a definite agency problem with emerging markets manipulating their currencies. Detroit complains that it promotes their exports unfairly. I say that's a wash: we get Wal-Mart and cheap capital, they build industries. The real implication of artificially cheap emerging currency is that, ultimately, it makes interest rates too low: globally, we produce too much and don't consume enough, meaning we save too much and can only find yield in risky investments (read: asset bubbles). Remember the food crisis? Another consequence of this system.

    (2)I am skeptical that there can be another reserve currency. It can't be in a nation with a long term trade-surplus. You want your reserve currency to be invested in something safe. History shows us that surplus-running nations don't seek yields. The US Treasury is 'risk free' not because we mange finances well, but because a world where the US defaults is terrifyingly difficult to imagine. It probably owes more to the size of our military and faith in our political system.

    Europe can't offer that. I think the financial crisis will prove to demonstrate that. The Euro has a higher interest rate now and is therefore more valuable because they can't agree on an approach to end their recession. They couldn't agree on a stimulus package of appropriate size. They are, simply, too politically divisive now. I think we will find that their inability to coordinate a response to a financial crisis will make their recession last longer (they really SHOULD lower interest rates and offer more substantial stimulus packages, but they can't get it together–Germany wants a smaller
    stimulus, Poland wants a larger one and France fears inflation.) In the near-ish term, I suspect this will mean that the euro will fall (but mabye not relative to the dollar). In the long run, I don't think anyone will seriously take a reserve currency from a zone unable to coordinate monetary policy.

    (3) Owing china so much debt will force a congenial relationship when it otherwise might not exist. I would worry more about trade wars if we were not, for the forseeable future, tied at the hip to China. I am not advocating Lloyd Bensten's approach: threatening to inflate the dollar if we don't get the concessions we want.