eichengreen dollar epilogue crash

CHAPTER 7
DOLLAR CRASH
But what if the dollar does crash? What if foreigners dump their holdings and abandon the currency? What, if anything, could U.S. policymakers do about it?
It would be nice were this kind of scenario planning undertaken by the Federal Reserve and Central Intelligence Agency, although recent events are not reassuring about the capacity of U.S. officialdom to anticipate the worst. Were it undertaken, it would have to start with what precipitated the crash and caused foreigners to abandon the dollar.
One trigger could be political conflict between the United States and China. The simmering dispute over trade and exchange rates could break into the open. American politicians who see China’s failure to revalue its currency more quickly as giving it an unfair competitive advantage, resulting in a chronic trade imbalance and U.S. unemployment, could impose an across-the-board tariff on imports from the country. Beijing would not take this lying down. Or the United States and China could come into conflict over policy toward rogue states like North Korea and Iran. Imagine that the United States took military action against one of those regimes, contrary to the wishes of Beijing. Again, China might be tempted to do something significant to register its protest.
One way for China to vent its anger and exert leverage over the United States would by using its financial weapon. Official Chinese agencies hold 13 percent of all U.S. government securities. Dumping them would send the bond market into a tizzy. As soon as they realized that the Chinese government was selling, other investors would pile on. Interest rates in the United States would spike. The dollar would crater. This demonstration of its vulnerability could cause exporters, importers, and investors to abandon the dollar permanently.
How plausible is this scenario? Some history may help to frame the answer.
EAST OF EDEN

One instance where the financial weapon was used to advance geopolitical ends, by none other than the United States, was the 1956 Suez Crisis. In the era before supertankers, 70 percent of Western Europe’s oil passed through the Suez Canal (modern supertankers are too large to navigate the channel). Transiting the canal reduced the cost of transporting tin and rubber from the British colony of Malaya and more generally of shipping goods between Asia and Europe. Hence Britain maintained a garrison of 80,000 troops at Suez and, together with France, exerted financial control of the Suez Canal Company.
Egypt, experiencing the same upsurge of nationalism as other Third World countries, sought to revoke the lease of the Franco-British consortium starting in 1952. Following the military coup that overthrew the monarchy on July 22 and brought General Gamal Abdel Nasser to power, Egypt’s relations with Britain and more generally with the West grew increasingly strained. In 1954 Nasser obtained agreement by Britain to withdraw its troops from the canal garrison. He upped the ante by recognizing the People’s Republic of China in 1956.
The United States, allied with Taiwan and hostile to mainland China, responded by halting financial support for Egypt’s Aswan Dam project. Britain had engineered the dam, British hydrologists having been involved in earlier projects at Aswan. But the United States financed it, reflecting Britain’s straitened circumstances. The Eisenhower administration’s abrupt decision betrayed the influence of the brusk cold warrior John Foster Dulles. The president was recuperating from intestinal surgery at the time, putting the hard-edged Dulles effectively in charge of foreign affairs.
Dulles was confident that Nasser would back down, but the Egyptian president was unwilling to compromise. The High Dam was his pyramid, the symbol of the proud modern Egypt he was seeking to create. Nasser therefore retaliated by revoking the Anglo-French concession at Suez and nationalizing the canal. The 70,000 French shareholders in the Canal Company were predictably outraged. A further grievance of the French government was Nasser’s support for the Algerian rebellion, which aggravated France’s political and military problems in North Africa.1
In response the French negotiated a secret pact with Israel. The Israelis had long objected to Nasser’s interference with their shipment of goods through the canal. More immediately they were alarmed to learn that Egypt had just purchased a shipment of MiG fighters from the Soviet Union. (The planes came via the Soviets’ client state Czechoslovakia, but no matter.) The information acquired new urgency with the arrival in Egypt of Russian and Czech pilots to fly the planes.2
After a series of cloak-and-dagger meetings with the French, Britain joined the alliance. When on October 29 Israel preemptively launched an incursion into Sinai, Britain and France moved to seize the canal, ostensibly to protect it from both Israeli and Egyptian forces. British and French planes bombed Egypt’s airfields. (So much for the MiGs.) Nasser responded by sinking all forty-seven ships transiting the canal, closing it to shipping. Although goods and petroleum from Asia and the Middle East could still reach Europe via the Horn of Africa, the extra cost and time were enormous. Nasser’s action produced among other things a horrific naval traffic jam in Cape Town, as three times the normal number of ships began arriving there for refueling.3
Although French paratroopers and British commandos were able to seize control of the canal at low cost to themselves, the damage had been done. In particular it had been done to the special relationship between the United States and Britain. Rather out of character for such a skilled diplomat, Conservative prime minister Anthony Eden had not obtained Eisenhower’s agreement prior to launching the operation. He simply assumed that the U.S. president would support action against an Egyptian government that had recognized a Chinese regime actively hostile to America’s Taiwanese ally.
Part of the explanation may have been Eden’s blind fury with Nasser. Eden was notoriously vain, emotional, and given to fits of anger. He had tendered an emotional resignation as foreign secretary in 1938 when the prime minister, Neville Chamberlain, approached the Italian dictator Benito Mussolini behind his back. It didn’t help that Nasser’s nationalization of the canal discredited the British policy of conciliation of which Eden had been the principal architect. During his third stint as foreign secretary in 1951–1955 (the second having been during World War II), Eden had personally negotiated the withdrawal of British troops from their Suez base.
Nasser having poked a stick in his eye, Eden now set his mind on toppling the Egyptian leader. Half measures would not do. As he put it in response to a memo from Anthony Nutting, his minister of state for foreign affairs, advocating a more diplomatic approach, “What’s all this poppycock you’ve sent me?…What’s all this nonsense about isolating Nasser, or ‘neutralizing’ him, as you call it? I want him destroyed, can’t you understand? I want him removed…. And I don’t give a damn if there’s anarchy and chaos in Egypt.”4
Misunderstanding also flowed from the fact that Eden never developed much of a relationship with the U.S. ambassador to London, Winthrop Aldrich—who happened to be the son of the Nelson Aldrich who played a leading role in the founding of the Fed and the dollar’s rise to international prominence. Normally the American ambassador would have been a conduit for information on the views of the president and the State Department. But Eden was on cool terms with Aldrich, who seemed more interested in London society than foreign policy.
A final factor was Eden’s reliance on Harold Macmillan, his chancellor of the exchequer.5 Macmillan was blindly confident that Britain could depend on its special relationship with the United States. Macmillan had his own personal relationship with the United States, his mother having been born in Indiana. He also had a special relationship with the American president, having served as wartime liaison between Prime Minister Churchill and Eisenhower when the latter was supreme allied commander of the North African theater. Macmillan was smuggled into the White House to meet with Eisenhower on a trip to Washington to attend the annual meetings of the International Monetary Fund and World Bank shortly before the Suez invasion. Whether Suez was discussed is disputed, but Macmillan, when cabling his prime minister, left no doubt about the views of the American president. “Ike,” he wrote, “is really determined, somehow or other, to bring Nasser down.”6
Wishful thinking this. The last thing Eisenhower and his State Department wanted in the wake of the Soviets’ suppression of the Hungarian Revolution was to side with an occupying power. Dulles was critical of anything that smacked of colonialism, which he saw as weakening the United States in the Cold War. Meanwhile the U.S. Treasury, under George Humphrey, Eisenhower’s closest friend in the Cabinet, opposed extending American support because of its budgetary implications.
The British also misunderstood U.S. electoral politics. The fact that Eisenhower was running for reelection in November 1956 gave them confidence that he would stand with Britain and Israel against the Egyptians. In fact, the American electorate had little appetite for another military adventure. For Eisenhower, who was campaigning on his record as a peacemaker, opposing the Suez incursion was a political winner. To British surprise, the United States demanded an immediate halt to military operations.
LESS THAN STERLING

Such was the geopolitical context. The financial background was the vulnerability of sterling. Britain’s foreign creditors still sought to shed the financial claims they had acquired during World War II, and the country’s increasingly porous capital controls gave them the opportunity to do so.7 Meanwhile high wages, low productivity, and adversarial labor relations prevented Britain from developing a strong export economy to offset its weak finances. Even before the Suez incursion, British reserves had fallen perilously close to the $2 billion viewed as the minimum safety level.8 Against this backdrop, an expensive and uncertain military campaign was risky.9 Closure of the canal would increase the cost of shipping and raise the price of imported oil. The Suez adventure thus catalyzed market doubts about the sustainability of the $2.80 pound-dollar exchange rate.
A fall in that exchange rate might have far-reaching consequences. Commonwealth countries, as well as Northern European countries accustomed to tying their currencies to the pound, would have to decide whether to follow. They might choose instead to maintain their link to the dollar, the currency of a stronger economy and larger trader. If so, the cohesion of the sterling area, and the practice on the part of its members of banking in London, would be casualties.10
Even before the Suez operation, then, the Eden Government knew that in order for the $2.80 sterling-dollar exchange rate to hold, it would need help from the IMF. This was where Eden and Macmillan were confident they would receive unconditional American support. And it was where their judgment proved fatally wrong. The State Department warned that the United States would support a request for assistance only in return for a commitment by the British Government to withdraw its troops. On November 2 the United States then introduced a cease-fire resolution in the UN General Assembly. By making public the spat between the United States and the UK, this action precipitated a run on the pound.11 The attack intensified when the United States made clear that it was insisting on not just a cease-fire but the physical withdrawal of troops.12
At this point Macmillan, who had been the staunchest supporter in the Cabinet of military action against Nasser, abruptly switched sides. He was accused of inconsistency, even duplicity, by the opposition. “First in, first out Macmillan” was the way they put it. But as financial water carrier for the government, he could hardly have done otherwise. His real failing was his earlier overconfidence about the prospects for American help.
For two weeks the British Government prevaricated, accepting the ceasefire but agreeing to withdraw only one battalion. Capital controls slowed the loss of reserves, but speculators, seeing devaluation as increasingly likely, found ways around them. Foreign purchasers of British goods delayed paying, given the likelihood that that the pound was about to be reduced in value.13 Sellers of goods to Britain insisted on being prepaid.
Climbing down was painful. A group of Conservative backbenchers known as the “Suez group,” reluctant to acknowledge that Britain was no longer a geopolitical power of the first rank, opposed all troop withdrawals. The Eden Government sought a commitment on financial assistance that could be used to secure Cabinet consensus on withdrawal. But the Eisenhower administration continued to demand a British commitment to withdraw by a date fixed. The British worried that setting a date might mean disorderly withdrawal, jeopardizing the safety of the troops. Eden, in poor health and now suffering from exhaustion, flew off for an extended period of recuperation at Goldeneye, the holiday home of the novelist Ian Fleming in Jamaica. This did not inspire confidence in his government.
Everyone knew that the crisis would come to a head on December 4, when Macmillan would make his regular monthly announcement of Britain’s reserves. It would show gold and dollar holdings below $2 billion, almost certainly triggering the final run on the pound. Under pressure of time, the Eden Government offered increasingly firm commitments to withdraw while still trying to avoid being pinned down to a date. It temporized with convoluted language, promising Washington, “[We] have decided to go without delay and we intend to go without delay.”14
But the Americans held all the cards. They could force concessions simply by doing nothing. On December 2, with the chancellor’s speech two days away, the Cabinet agreed to a December 22 deadline for the withdrawal of troops. On December 3, Secretary Humphrey, back in the office after a short vacation, agreed to support a British drawing from the IMF.
When Macmillan reported on December 4 that the Bank of England’s reserves had fallen below $2 billion, he was therefore able to announce American support for Britain drawing its entire $1.3 billion credit line at the IMF.15 On December 10, with U.S. support, Britain’s application to borrow was approved; of the sixteen members of the IMF Executive Board, only the director representing Egypt abstained.16 This action marked the end of the financial crisis. It also marked the end of the era when a country that had once been economically strong, Britain, could pursue a foreign policy independent of a now stronger partner, the United States.
A PARALLEL TOO FAR

This history is suggestive for those contemplating the financial implications of a foreign-policy conflict between the United States and China. But the only thing it has in common with a potential Sino-American conflict is the vulnerability of the currency of one of the principals. One important difference is that a China that caused the U.S. bond market and dollar to crater would be inflicting significant financial damage on itself, since it would be pushing down the value of its dollar assets. The American government’s holdings of British securities were barely $1 per American resident in 1956. Financial losses to American investors as a result of a decision not to support sterling would have been negligible. The United States could credibly threaten steps that might lead to a sterling crisis without worrying about self-inflicted financial losses.
Today, in contrast, Chinese holdings of U.S. government and agency securities exceed $1,000 per resident. Losses to China from a decision to use those holdings to advance geopolitical ends would be harder to ignore. Given the magnitude of its holdings, it is not clear who would be hurt more. There is no ruling out that China might take precipitous action in a fit of pique. But it is more likely to think twice.
Similarly, the United States when tightening the screws did not have to worry about damaging its access to foreign markets. Its merchandise exports were barely 5 percent of U.S. GNP. Less than a twentieth of those exports—5 percent of the 5 percent—went to Britain. Even if sterling depreciated sharply and the British economy went into a tailspin as a result of America’s failure to help, the impact on the U.S. economy would have been modest. Even had Britain retaliated by slapping tariffs on U.S. exports, there would have been only a minor impact on the United States. Knowing this, the United States was undeterred in using its financial weapon.
Contrast China today, 40 percent of whose GNP is in the form of exports, a quarter of which go to the United States. A sharp fall in the dollar that created financial problems for the United States would hit Chinese exporters in the pocketbook. The fallout from the 2007–2008 crisis just hints at the consequences. Chinese exports fell by 17 percent in 2009 as a result of the crisis in the United States. The Chinese authorities were able to prevent a significant economic slowdown by applying the single largest fiscal stimulus, as a share of GNP, of any country. They were aided by the fact that their trading partners, including the United States, did not resort to overt protectionist measures, and that governments around the world cooperated in applying monetary and fiscal stimulus to stabilize the global economy.
The situation would be different in the event of a Sino-American conflict. The U.S. would respond with trade sanctions if China was seen as using its financial weapon to roil U.S. markets. The damage to China’s exports would be more serious than in 2008–2009. Stabilizing the world economy would be harder, given the inability of the two countries to cooperate. The potential for wider damage would cause China to hesitate.
MARKETS OUT OF CONTROL

Instead of geopolitics, the trigger for a dollar crash could be a sudden shift in market sentiment. Investors might wake up one morning and decide that holding dollars was a losing proposition. With the smart money leading the way, other investors would follow. If we know one thing about investors, it is that they are erratic. Markets can crash. Investors can run with the herd. Currencies can fall prey to investor panics.
A sharp fall in the dollar in a short period—say, a 50 percent fall like that experienced by the Korean won following the failure of Lehman Bros.—would catch some investors off-guard. Anyone still holding dollars would suffer catastrophic losses. There could be a cascading wave of defaults. The solvency of institutional investors and the stability of the global financial system could be placed at risk.
And even if this risk was contained, there would be other fallout. The other currencies into which investors piled would appreciate sharply. Europe’s competitiveness problems would be aggravated. Rising unemployment, laid at the doorstep of a depreciating dollar, could trigger a protectionist backlash.
In the wake of these events, foreigners would come to think twice about using an unstable dollar. Exporters would shift to other currencies for invoicing and settling their trade.17 Bondholders would shun dollar-denominated claims. This would be the tipping point where the dollar lost its international currency status. America’s exorbitant privilege would be no more.
Only one thing is wrong with this scenario. It assumes that the Fed wouldn’t intervene to support the dollar. Under normal circumstances the Fed doesn’t intervene in foreign exchange markets. Instead it targets price stability and employment growth. But this panic would not be normal circumstances. In the face of a plunge that it saw as resulting from panic, the Fed would surely step in to support the dollar, buying it up on foreign exchange markets. It would make it more expensive for investors to bet against the currency by raising interest rates. And if it was right that the cause of the dollar crisis was panic pure and simple, the currency would recover. Panics do not last forever. Investors eventually realize they have overreacted. The Fed’s intervention would be a plausible occasion for their coming to their senses. With the Fed buying low and selling high, its intervention might even be profitable.
To carry out this operation, the Fed would need help from its friends. Its capacity to buy dollars is limited by its reserves of foreign currencies, which are small relative to the scale of the problem. The situation would not be unlike the 1960s when the United States required assistance from Germany and other European countries to maintain the dollar’s peg to gold.18
Back then, of course, it was mainly our friends holding our financial liabilities. The fact that the geopolitical interests of China, Russia, and the oil-exporting countries of the Middle East, U.S. creditors all, are not fully aligned with ours leaves one less confident now that their help can be counted on.
Geopolitics notwithstanding, foreign governments have the same interest as the U.S. Treasury and the Fed in preventing a self-fulfilling run on the dollar. They will not want to see their firms experience a serious loss of competitiveness. They will not want to see investors suffer gratuitous balance-sheet damage. Given their shared interest in the stability of a global system in which the dollar plays a leading role, they too will have an incentive to intervene. And in the scenario where intervention is profitable for the Fed, it is profitable for other central banks. Again, the self-interest of all those concerned would work to prevent problems from getting out of hand.
DEFICITS OUT OF CONTROL

Thus, the plausible scenario for a dollar crash is not one in which confidence collapses on the whims of investors or as the result of a geopolitical dispute but rather because of problems with America’s own economic policies. The danger here is budget deficits out of control.
Chronic budget deficits have frequently been the precipitant for crises. Recent experience in Greece, Portugal, Spain, and elsewhere in Europe illustrates how the process works. The longer a government runs deficits, the higher its debt and interest payments mount. Those payments lay claim to a growing and ultimately excessive share of available tax revenues. Investors may be lulled into complacency for a time by the government’s promise to put its fiscal house in order, if not today, then tomorrow. But one morning they will wake up with a start and conclude that the debt is unsustainable. They will sell its bonds en masse, and its currency will collapse on the foreign exchange market.
The implications for the United States would not be pretty. Bond prices would plunge as investors scrambled to get out. Interest rates would spike. With foreign investors among those liquidating their positions, the dollar would collapse to lower levels. If this happened all at once, the results could be devastating.
The Fed may again step into the breach, buying up bonds to support the market and prevent treasury yields from spiking.19 But in contrast to the previous scenario, in this case the Treasury will at the same time be flooding the market with additional debt. The Fed will be compelled to buy this debt, too, if private demand has evaporated. Investors will see this as a process without end. They will see the Fed’s bond purchases and the cash that it is pumping into the economy as auguring inflation, which will mean further dollar weakness, and worse. The decline in the currency will feed on itself. In the face of these problems, there really could be mass migration away from the dollar.20
The fate of the dollar ultimately hinges, in this case, on U.S. budgetary policy. And here are there are grounds for concern. Three, actually. First is the deterioration in the fiscal position prior to the financial crisis. The 2001 and 2003 tax cuts pushed revenues to their lowest level as a share of GDP since 1950, while the decision to add a prescription drug benefit to Medicare and fight two expensive wars eliminated any pretence of cutting spending. Together these tax cuts and unfunded spending increases pushed the budget from surplus in 2000 to a structural deficit of 4 percent of GDP in 2007–2008. Given the interest that now has to be paid on the resulting debt, the impact on the deficit only rises with time.
Second, there are the eye-popping deficits resulting from the financial crisis. Budget deficits were unavoidable under the circumstances; tax receipts collapsed, and the government had no choice but to step up and replace some of the private spending that evaporated in the crisis. But the resulting deficits were enormous: the 11 percent of GDP deficit in 2009 was not just unprecedented in peacetime; it was larger than the national income of all but six other countries in the world. The 2010 deficit was larger. The official line is that these deficits will now be reversed out in short order, but whether this maneuver can be accomplished is dubious at best.


Figure 7.1. Components of the U.S. Budget Deficit.
Source: Center on Budget and Policy Priorities analysis based on CBO estimates as of February 17, 2010.

Third, there is the prospect of even larger deficits once the baby boomers start retiring in large numbers around 2015, raising health and pension costs. This is what the country’s efforts at health-care reform are all about.
But it is not necessary to look that far ahead to see trouble. The current trajectories of revenues and spending imply that federal government debt will have risen from 40 percent of GDP before the crisis to 75 percent by 2015, net of obligations to social security and other government trust funds.21 Debt ratios will rise even faster if the economy’s growth potential has been permanently damaged by the crisis, as many observers believe. Growth 1 percentage point slower would raise the debt/GDP ratio by 5 additional percentage points by 2011 and by 10 additional percentage points by 2015.
It will not be easy for the United States to cope with a debt/GDP ratio of 75 percent. This sort of burden is manageable for a government that takes 30 to 40 percent of national income in taxes, as is typical in Europe. But it is more difficult for a U.S. government whose tax revenues are only 19 percent of GDP in a normal year.
With one out of every five tax dollars committed to interest payments, it will be tempting to maintain other services by running deficits and issuing additional debt.22 At some point, however, investors will recognize this behavior for the Ponzi scheme it is. They will understand that U.S. alternatives ultimately reduce to measures to drive down the real value of the debt, presumably by inflating it away. Since investors look forward, they will want to close out their positions before this inflation happens.
If foreign investors refuse to accumulate additional dollar securities as they flow onto the market, U.S. interest rates could rise by a full percentage point.23 More alarmingly, foreign investors could become unwilling to hold dollar securities, period. Selling their holdings will have even larger interest-rate and exchange-rate effects than simply refusing to absorb additional issues. Anticipating continued dollar depreciation, residents of other countries will see no reason to risk pricing their exports in dollars. They will not accept payment in that form, just as Britain’s creditors refused to accept sterling in 1956.
If history is any guide, this scenario will develop not gradually but abruptly. Previously sanguine investors will wake up one morning and conclude that the situation is beyond salvation. They will scramble to get out. Interest rates in the United States will shoot up. The dollar will fall. The United States will suffer the kind of crisis that Europe experienced in 2010, but magnified. These events will not happen tomorrow. But Europe’s experience reminds us that we probably have less time than commonly supposed to take the steps needed to avert them.
Doing so will require a combination of tax increases and expenditure cuts. At 19 percent of GDP, federal revenues are far below those raised by central governments in other advanced economies.24 With spending on items other than health care, Social Security, defense, and interest on the debt having shrunk from 14 percent of GDP in the 1970s to 10 percent today, there is essentially no nondefense discretionary spending left to cut. One can imagine finding small savings within that 10 percent, but not cutting it by half or more in order to close the fiscal gap. It is wishful thinking to believe that there exists that much waste and fat. And after 2015, as the baby boomers retire, current budget plans imply federal government spending on the order of 25 percent of GDP. Under current law, federal spending will rise to 40 percent of GDP over the subsequent quarter century, which is just a way of saying that current law cannot remain unchanged.25
A new era of peace and reconciliation may descend on the world, allowing for additional reductions in defense spending. Or there may be agreement on further health-care reform that significantly bends the cost curve for service delivery. It is not clear which scenario is more fanciful. It hard to avoid the conclusion that restoring fiscal balance will require dealing with entitlements. It will require agreement to limit pension costs by raising the retirement age. The problem of funding Social Security can be alleviated by liberalizing immigration policy. There will also have to be agreement on what American politicians euphemistically refer to as “revenue enhancement.” One can imagine imposing higher gasoline taxes at the pump or auctioning off greenhouse gas permits. One can imagine the imposition of a value-added tax. But with a Republican Party unconditionally opposed to all new taxes, a Democratic president who campaigned on a promise not to raise the taxes of the middle class, and a well-organized American Association of Retired Persons to lobby against Social Security and Medicare cuts, it is uncertain whether any of these sensible outcomes can be produced by normal congressional politics.
Hence the allure of taking the decision out of the hands of the Congress and placing it in those of a benevolent bipartisan commission. Congress would provide the mandate—it would specify the pace at which the commission was instructed to close the deficit. All taxes and spending programs would be on the table, including Social Security, Medicare, and Medicaid. Unlike the Congress, where every member represents his or her own narrow constituency, this commission could proceed with the national interest in mind. The Congress would be presented with a package in which everyone’s ox was gored, but only slightly. The commission’s recommendations would then be voted up or down by the House and Senate without amendment.
This is not an unreasonable idea, but neither is it guaranteed to work. If the Congress is reluctant to see taxes raised or spending cut, it will hesitate to give a commission true independence. It will be reluctant to bind itself to accept or reject its recommendations in a single up-or-down vote. A bipartisan commission created by executive fiat that lacks buy-in from the opposition and whose recommendations the Congress is not bound to accept or reject without amendment is unlikely to have much effect. Even if the Congress does commit to either accepting the commission’s recommendations or else leaving the government without a budget and incapable of providing essential services, one should not underestimate the capacity of legislators to do the wrong thing. For anyone dubious of the proposition, I have just one word for you: California.
In the end there is no substitute for achieving political consensus in the Congress and nationally on how to solve the fiscal problem. Procedural changes can help. But meaningful reform will require political consensus on the ends to which procedural changes are the means. A dollar crisis could be the event that precipitates the necessary reforms. Better, of course, would be the mere possibility of a dollar crisis.
This said, the United States is not the only economy with fiscal challenges. Europe and Japan have even heavier debts. The euro area, having received an early wake-up call, is now making strenuous efforts to put its fiscal house in order, but it will be years before we learn whether it succeeds. Japan, confident that it is safe because its debt is held almost entirely by its own residents, has barely begun doing likewise. The task for both is complicated by slowly growing labor forces and rapidly aging populations. The dollar’s prospects may be bleak, but, as always when thinking about exchange rates, it is necessary to ask: bleaker than what? People have been wrong before when betting against the U.S. economy. They have been wrong before when betting against the dollar. They could be wrong again.
Or they could be right, in which case the dollar’s exorbitant privilege will be no more.
LIFE UNDER PRESSURE

If the dollar loses its international status, foreign investors will have little appetite for dollar claims. When lending to an American company, they will lend in other reputable international currencies. They will demand that American corporations issue bonds and commercial paper in those other currencies. Skeptical that the dollar will retain its value, they will lend to the U.S. government only if the Treasury issues bonds denominated in foreign currencies.
American economic policy will have to be adapted accordingly. Most obviously the Fed’s benign neglect of the exchange rate will have to be abandoned. Customarily the Fed focuses on inflation and employment growth.26 It attempts to strike a balance between these dual objectives. It concerns itself with the exchange rate only insofar as there are implications for these other variables.27 When a Fed chairman actually says something about the currency, as Ben Bernanke did in November 2009 in response to a bout of dollar weakness, the markets take notice precisely because the subject is addressed so rarely.28
This is in contrast to countries lacking America’s exorbitant privilege. When they borrow abroad, they borrow in someone else’s currency, since the lenders have no particular use for their national money. If the local currency then depreciates, borrowers get smashed, since their foreign-currency obligations become more expensive to service and repay. And, knowing this, the central bank is forced to jack up interest rates to limit the depreciation. This is the “fear of floating” syndrome in emerging markets whose liabilities are in someone else’s money.29 It forces central banks to compromise their pursuit of other goals in order to keep the exchange rate from moving excessively. Insofar as they are forced to more closely align their interest rates with those in the rest of the world in order to keep the exchange rate stable, it gives central banks less room for maneuver.
A Fed constrained in this way would not be able to cut rates to low levels as it did to counter the recession that followed the collapse of the high-tech bubble and 9/11. With interest rates significantly lower in the United States than other countries, the dollar declined by 30 percent between 2001 and 2004. Given America’s exorbitant privilege, the Fed could treat this depreciation with benign neglect. Since U.S. international competitiveness was enhanced, it could see depreciation as part of the solution rather than part of the problem.
If we find ourselves in a new world where significant amounts of U.S. debt are in other currencies, the Fed will no longer be able to disregard the financial consequences. Well before the dollar’s fall reached 30 percent, the Fed would be forced to raise rates. American monetary policy would have to hew to the line set by foreign central banks. Welcome to the club, the Fed’s friends in less developed countries would no doubt say. In this way the United States would resemble an emerging market.
Moreover, the United States would be dependent on the generosity of others in the event of a crisis. When in 2008 banks stopped lending and financial markets seized up, the Fed could provide emergency liquidity to cash-starved banks and firms because their bills were denominated in dollars that the Fed could print. Contrast this situation with South Korea, where banks and firms had borrowed abroad in dollars. The capacity of the Bank of Korea, the country’s central bank, to provide banks and firms with the resources needed to avoid defaulting on their dollar obligations was limited to the Bank’s dollar reserves—since the Bank of Korea can only print won. When in November 2008 the Bank’s reserves fell to the psychologically important $200 billion regarded as the prudent minimum, indicating that it might be forced to halt such lending, panic set in.30 (Recall that $2 billion was seen as the prudent minimum for the Bank of England’s reserves in 1956; add two zeros and you have Korea.) Foreign banks refused to roll over their loans. The won collapsed on the foreign exchange market. The situation stabilized only when the Fed announced that it was loaning its Korean counterpart $30 billion, enabling the Bank of Korea to lend dollars to banks and firms with bills in dollars to pay.31
In a world where American banks and firms are forced to borrow abroad in foreign currencies, the Fed will find itself in the position of the Bank of Korea. In a crisis where foreign banks stop lending and financial markets seize up, not only will U.S. banks and firms be unable to get their hands on the foreign currencies needed to keep current on their debts, but the Fed will not be able to help them, since it can’t print those foreign currencies. It will have to rely on foreign central banks to provide it emergency loans like those the Fed provided them in 2008. Financial stability will hinge not just on the Fed doing the right thing, but on foreign central banks doing the right thing. America’s fate will be in foreign hands. Foreigners may seek to exact a price from the United States in return for their assistance. In a crisis the United States will have little ability to resist.
The U.S. government could also, in principle, appeal to the International Monetary Fund, the other important source of emergency liquidity in the 2008 crisis. For foreign critics of the IMF who have long accused it of imposing on them U.S. wishes, this is a delicious possibility. But American financial markets are large relative to the resources of the IMF. Unless the Fund was very considerably expanded, which is unlikely, it would lack the capacity to provide emergency liquidity on the scale that would be required by U.S. banks and markets.
TIGHTER BELTS

How much difference will it make for American living standards if foreign central banks and governments no longer turn to the United States and the dollar for reserves and no longer finance U.S. external deficits so readily? No question, Americans will have to tighten their belts. We will no longer be able to consume and invest a trillion dollars more than we produce each year simply because central banks and other foreign investors have a voracious appetite for dollars that require no real resources to supply. It will no longer be possible for us to import goods and services amounting to $1 trillion in excess of what we export. The days will be over when the United States can run a current account deficit of 6 percent of national income without tears. The United States will have to cut its trade deficit. It will have to export more.32
Doing so will mean making our exports more attractive. Their cost will have to be lower, their quality higher. This can be accomplished by raising the efficiency of American industry or limiting payments to the factors used in their production. Raising efficiency—increasing the quality and quantity of the output produced by our firms and workers—is of course the happier alternative. Unfortunately, increases in efficiency can’t be willed into existence; they have to be achieved. And in order to deliver an improvement in the U.S. trade balance, they have to be achieved faster than in countries with which we compete.
Here the United States has some obvious strengths. It has large numbers of university-and industry-based scientists, many attracted from other countries. With high-powered incentives for entrepreneurs and an agile venture capital industry, it has a demonstrated ability to develop innovative technologies. With low hiring and firing costs and flexible labor markets, it is quick to commercialize those innovations. The United States also has an abundance of fertile land that supports a profitable agribusiness sector, something that is increasingly valuable in a food-scarce world.
But much of the country’s physical infrastructure is antiquated and difficult to modernize, partly by virtue of the fact that it is under the jurisdiction of a multitude of state and local governments or in private hands. Freight railways own much of the track used by Amtrak, for example. Contrast the difficulty of building a high-speed train line from New York to Chicago with China’s rapid completion of a high-speed link between Beijing and Shanghai—or for that matter with France’s, Germany’s, and Spain’s high-speed trains. China plans to build as much as 8,000 miles of high-speed rail by 2020. In the United States, meanwhile, intercity rail service is now actually slower than in the 1940s. Market economies have their strengths, but when it comes to some tasks it helps to be a planned or, like Europe, mixed economy. Were Dwight Eisenhower to come along today and propose building the interstate highway system, no doubt he would be accused of socialism.
Similarly, the United States is no longer the beneficiary of an increasingly well-educated labor force. The current generation is the first in more than a century whose educational attainment does not significantly exceed that of its parents. Claudia Goldin and Lawrence Katz estimate that the educational attainment of an American born in 1975 is just six months more than that of his or her parents born in 1951. By comparison, the educational attainment of an individual born in 1951 was more than 2 years greater than that of a person born in 1921.33 Meanwhile a variety of middle-income countries with which the United States competes continue to boost their levels of education. The gap is closing. And for those who go straight from secondary school to work, the United States lacks effective vocational training like that which exists in Europe.
Nor can the United States count on high levels of private investment. The additional public debt inherited from the financial crisis will have to be serviced. Servicing it will mean higher taxes. Ensuring that new bonds are willingly taken up when existing bonds mature will require higher interest rates. Higher taxes and interest rates are burdens for investors. They do not bode well for capital formation. They do not bode well for the dollar.
These problems can be fixed. Together with economic growth, budget surpluses can reduce public debt relative to taxes and national income. But even if the will exists, completing the task will take time. Decaying roads and bridges can be repaired. New ones can be built. But this revitalization, too, can occur only over a period of years. The country can invest more in education, but again time will have to pass before the graduates receive their degrees and enter the labor force.
It is not clear that the markets will wait. If they don’t, the country will have to adjust in other ways. Absent a miraculous acceleration in productivity growth, the only way of exporting more will be by limiting costs. Employers can cut back on wages and nonwage costs like health insurance. But after a decade in which average labor compensation has stagnated and fringe benefits have been cut to the bone, there will be resistance to going down this road.
Alternatively, the adjustment can be left to financial markets. That is to say, the competitiveness of American exports can be enhanced by allowing the dollar to decline. Again, the result will not be pleasant. Walmart shoppers will pay more for their Chinese-made clothes. Your high-definition TV will become more expensive. But if the United States now has to export more as a result of no longer being the exclusive provider of international reserves to the world, this change is unavoidable.
Germany illustrates the point. Following strong spending growth in the 1990s when pent-up demand was released by German reunification, domestic demand stagnated. In Germany then, as in the United States now, the party could not last forever. As demand growth slowed, Germany had to export more for employment to rise. Fortunately, the country’s big trade unions, starting with IG Metall, the metalworkers’ union, understood the challenge. They agreed with management and government on a policy of wage restraint. They agreed to allow wages to grow more slowly, especially in the country’s eastern states, where output per worker was less.
Between 2003 and 2010, average hourly earnings Germany-wide rose by less than 1 percent per annum. Combined with respectable productivity growth, this policy of restraint reduced the cost of labor. Germany was able to boost its foreign sales at a double-digit pace. With exports increasing half again as fast as imports, it was able to strengthen its international accounts. Germany’s example illustrates the kind of adjustment now required of the United States.
But the other side of this coin is the continuing stagnation of living standards. From the trough of the business cycle in 2003 to the eve of the financial crisis in 2007, the consumption of German households rose by just 1 percent. While Germany’s example shows that adjustment is possible, it also shows that it comes at a cost.
Still, a decline in the dollar need not have a catastrophic impact on American living standards. The historical rule of thumb is that reducing the current account deficit by 1 percent of GDP requires the dollar to depreciate by 10 percent.34 Cutting the external deficit from 6 to 3 percent of GDP, which is what is required, would thus mean a 30 percent fall in the dollar against other currencies.35 The first third of this adjustment was accomplished, as it were, in the course of 2009, with the dollar falling 10 percent in the 11 months following President Barack Obama’s inauguration.
The dollar’s 2009 fall was disquieting, but there was no collapse of American living standards. The dollar exchange rate has regularly risen or fallen by 10 percent in a year. It has periodically fallen by as much as 30 percent in 2 or 3 years. It fell that much, adjusted for inflation, between 2001 and 2004, and there was no existential threat to the American way of life. It fell even faster between 1985 and 1988. While this 1980s episode was not a happy one, it did not produce an apocalyptic fall in U.S. living standards. To the contrary, the dollar’s fall only modestly affected the prices American consumers faced at the mall.36
DOLLAR DECLINE AS ELIXIR?

Some will argue that dollar depreciation and rebalancing the U.S. economy toward exports are to be welcomed, not resisted. Their argument is that the strong dollar that resulted from America’s exorbitant privilege has contributed to the hollowing out of American manufacturing industry. It has slowed learning on the job, there being fewer manufacturing jobs from which to learn, and delayed improvements in efficiency. All the while, other manufacturing-heavy economies, from Germany to China, were sprinting ahead.
Now, with a weaker dollar, the argument goes, the United States will produce more manufactured goods for foreign consumption and fewer fast-food meals for American households eating out less. With households tightening their belts (in both senses), there will be more good jobs and fewer McJobs. The distribution of income will be more equitable. Another way of thinking about this change is as a shift in the composition of what America exports from the treasury, agency, and derivative securities purchased by foreign central banks and private investors, toward John Deere earthmoving equipment, Boeing Dreamliners, and—who knows—maybe even motor vehicles and parts.
This shift will also help to redress the problem of income inequality, the advocates of a weaker dollar contend, since manufacturing uses more blue-collar labor than does financial services. The growth of income inequality in the United States in the last decade was largely accounted for by the exceptional increase in the compensation of the top 0.01 percent of earners. Suffice it to say that these folks were not assembly-line workers. A substantial share of that top-earning group was made up of the managing directors and executives of investment banks, hedge fund managers, and private equity and venture capital professionals.37 With the United States now producing and exporting fewer financial services, and with more blue-collar workers in good manufacturing jobs, it is argued, this trend will be reversed.
Other countries have boosted their manufacturing sectors by keeping their exchange rates low and exporting more of what they produce. The proposition is that the United States should meet fire with fire, not simply restraining the growth of labor costs à la Germany but also actively lowering its exchange rate in the manner of China.
WHY THAT WON’T WORK

Were it only true. It would be nice if a lower dollar could miraculously rejuvenate American industry and create large numbers of manufacturing jobs while narrowing income inequality. But the circumstances of the United States are not the same as Germany’s. Having long been the producer of capital goods for much of Europe, Germany is a dominant supplier of production equipment, now also to emerging markets. While it has other economic and financial problems, with a well-developed system of apprenticeship training providing legions of skilled mechanics, it never allowed its manufacturing sector to wither. Attempts to grow U.S. manufacturing employment would have a less favorable starting point.
The circumstances of emerging markets like China differ even more radically. China has been able to grow its manufacturing employment and raise the incomes of its unskilled masses by shifting rural peasants into assembly operations where they can learn the requisite skills in a matter of days. This is not unlike the situation in Highland Park, Michigan, a century ago when Henry Ford built the first assembly line. The simplicity of the technology used to produce the Model T, by our contemporary standards, made it possible to train up workers, many of whom were immigrants or straight off the farm, in less than a week.
The situation in the United States today is different. Manufacturing has migrated to developing countries—thankfully so, for this is what we mean by economic development. The spread of industrialization is lifting two-thirds of the world’s population out of poverty. Developing countries increasingly dominate industries that rely on unskilled and semiskilled labor that can be trained up in a week, since this is what they possess in abundance. This also means that the U.S. equivalent of China shifting a rural peasant into assembly operations is shifting a worker from the counter of a fast-food restaurant to the foundry of a semiconductor fabrication plant. But this is not how the world works. Manufacturing activities in which the United States is internationally competitive require skilled workers, not hamburger flippers. Given time, more Americans can acquire the skills and training to work in a semiconductor fab. But the fundamental constraint is imparting the skills, not simply lowering the cost of their labor.
Another way of seeing this point is to observe that manufacturing only accounts for a slim majority of U.S. exports of goods and services. Services, excluding interest payments on debt to foreigners but including things like the underwriting services of investment banks and insurance companies, the design services of engineering firms, and the business services of software companies and management consultancies, account for fully 30 percent. Most of the services the U.S. exports are provided by well-educated, high-skilled workers. Agriculture and products based on raw materials account for another 15 percent of exports.38 The United States, with its abundant, fertile land, has long been an exporter of agricultural products. But these are the exports of capital-intensive agribusiness, which employs relatively few workers, not of the late lamented family farm.
None of this should come as a surprise. The United States has abundant capital and skilled labor by the standards of emerging markets. Capital and skilled workers are the inputs used most intensively by its export industries and sectors.39 If you ask which U.S. plants have shut down as a result of Chinese competition, the answer is low-productivity plants with lots of production workers.40 An exchange rate 30 percent lower is not going to be of much help to an unskilled or semiskilled worker in the United States competing head to head with Chinese labor, especially when labor productivity in China is growing by 6 percent per annum.
Ramping up U.S. exports is desirable on any number of grounds. But it will benefit mainly capital and skilled labor, since they and not the unskilled workers whose jobs have migrated to developing countries are the factors used intensively in the production of those exports. Changes in exchange rates cannot solve all problems. If Americans are concerned, as they should be, with income inequality, they will need to address it through other means, be they changes in the tax code and caps on bankers’ bonuses or more investment in education and training.
LEVERAGING UP

Concern with the consequences of the dollar losing its exorbitant privilege is not limited to the pocketbook. A weaker dollar, security specialists warn, will make it more difficult for the United States to project strategic influence and pursue foreign policy goals. Maintaining a foreign military presence will become more expensive. We will have less foreign aid money with which to win friends and influence people. American companies will be less able to make the strategic investments in, inter alia, West African oil refineries that cause countries anxious to attract our capital to take note of our preferences. Devalued dollars will be less capable of buying the cooperation of foreign governments.
Other countries with stronger currencies meanwhile will be doing all the things that we can no longer afford. China is investing in the Greater Nile Petroleum Operating Company that controls Sudan’s oil fields, making it harder for the United States to pressure Khartoum to abandon its human rights violations in Darfur. Whereas the United States is cutting the budget for Radio Free Europe/Radio Liberty, China Radio International provides 19 hours of daily programming from its transmitter in Kenya.
And as a net foreign debtor, America will depend on the generosity of others, creating a pressure point for them to exploit. Not only will other countries grow more assertive, but the United States will be more reluctant to cross them. Foreign debtors have weak currencies. And no foreign debtor, it is said, remains a great power for long.
Such warnings make sensational newspaper copy, but they misdiagnose the problem. The shift from a world where the dollar was the dominant international currency to one in which is now obliged to share that role will in fact have only minor implications for the ability of the United States to pursue its geopolitical goals. It is hard to see how having to narrow our current account deficit by 3 percent of GDP, which would be the implication of other countries no longer relying primarily on dollars for their reserve needs, would fundamentally transform America’s position in the world. It is hard to see how a dollar exchange rate 30 percent lower—a 30 percent fall, recall, being what is required to narrow the U.S. current account deficit by that amount—could make such a difference, given that the dollar has risen or fallen that much before without cataclysmic effects.
The fundamental determinant of U.S. strategic leverage is the basic economic and fiscal health of the nation. A nation whose economy does not grow loses political and strategic power. A government unable to raise sufficient revenues or rein in other expenditures will be unable to finance an adequate defense budget. It is this fact and not whether the dollar remains the world’s dominant reserve currency that is confronting the Pentagon with a further decline in U.S. defense spending from an already historically low 4 percent of GDP. And what is true of military power is true of soft power, what with China now sending more government-funded doctors than the United States to many parts of Africa. It is the cash-strapped fisc and not whether or not the dollar is the dominant reserve currency that prevents the United States from spending more on foreign aid or hosting more Fulbright scholars.
With the emerging markets in which two-thirds of the world’s population live growing faster than the United States, U.S. defense spending as a share of global output is shrinking even faster than U.S. defense spending as a share of U.S. output. This is simply a matter of arithmetic. It is also a reminder that the fundamental factor that has rendered the U.S. less dominant geopolitically is the same thing that has rendered the dollar less dominant financially, namely that the world is growing more multipolar. It is a reminder of the other thing the United States must do to maintain and strengthen its capacity to project geopolitical leverage besides putting its fiscal house in order, namely enhance its economic health generally. Britain’s loss of great-power status after World War II occurred not so much because she emerged from the war as a net foreign debtor as because her subsequent economic performance was dismal, leaving H.M. Government strapped for cash. It was this economic malaise, and not simply that Britain was a net foreign debtor, that forced the UK to withdraw from Greece in 1947. It was this, and not just that Britain owed the U.S. money, that led to its climbdown from Suez in 1956.
The point is that it is not the exchange rate or the net foreign investment position as much as the fundamental underlying health of the economy that matters for geopolitical leverage. If one wants a single unified explanation for the behavior of the exchange rate and the net foreign investment position, it would again be the fundamental underlying health of the economy. Whether the dollar rises or falls by 30 percent will matter much less for U.S. strategic influence than whether U.S. economic growth averages 2 or 4 percent per annum over the next decade.
Again, there is a more alarming scenario: instead of the dollar declining gradually to somewhat lower levels, there is a dollar crash. In this case all bets are off. Here it is important to remember that the only plausible scenario for a dollar crash is one in which we bring it upon ourselves. This also means that it is within our grasp to avoid the worst. The good news, such as it is, is that the fate of the dollar is in our hands, not those of the Chinese.