Economics focus
The dollar and the deficit
Sep 12th 2002
From The Economist print edition
Why the dollar still rules the world—and why the world should be grateful
THE dollar is looking vulnerable,It is propped up not by the strength of America's exports,but by
vast imports of capital,America,a country already rich in capital,has to borrow from abroad almost
$2 billion net every working day to cover a current-account deficit forecast to reach almost $500
billion this year,
To most economists,this deficit represents an unsustainable drain on world savings,If the capital
inflows were to dry up,some reckon that the dollar could lose a quarter of its value,Only Paul
O'Neill,America's treasury secretary,appears unruffled,The current-account deficit,he declares,is
a,meaningless concept”,which he talks about only because others insist on doing so,
The dollar is not just a matter for America,because the dollar is not just America's currency,Over
half of all dollar bills in circulation are held outside America's borders,and almost half of America's
Treasury bonds are held as reserves by foreign central banks,The euro cannot yet rival this global
reach,International financiers borrow and lend in dollars,and international traders use dollars,even
if Americans are at neither end of the deal,No asset since gold has enjoyed such widespread
acceptance as a medium of exchange and store of value,In fact,some economists,such as Paul
Davidson of the University of Tennessee and Ronald McKinnon of Stanford University,take the
argument a step further (see references at end),They argue that the world is on a de facto dollar
standard,akin to the 19th-century gold standard,
For roughly a century up to 1914,the world's main currencies were pegged to gold,You could buy
an ounce for about four pounds or twenty dollars,The contemporary,dollar standard” is a looser
affair,In principle,the world's currencies float in value against each other,but in reality few float
freely,Countries fear losing competitiveness on world markets if their currency rises too much
against the greenback; they fear inflation if it falls too far,As long as American prices remain
stable,the dollar therefore provides an anchor for world currencies and prices,ensuring that they
do not become completely unmoored,
In the days of the gold standard,the volume of money and credit in circulation was tied to the
amount of gold in a country's vaults,Economies laboured under the,tyranny” of the gold regime,
booming when gold was abundant,deflating when it was scarce,The dollar standard is a more
liberal system,Central banks retain the right to expand the volume of domestic credit to keep pace
with the growth of the home economy,
Eventually,however,growth in the world's economies translates into a growing demand for dollar
assets,The more money central banks print,the more dollars they like to hold in reserve to
underpin their currency,The more business is done across borders,the more dollars traders need to
cover their transactions,If the greenback is the new gold,Alan Greenspan,the Federal Reserve
chairman,is the world's alchemist,responsible for concocting enough liquidity to keep world trade
bubbling along nicely,
But America can play this role only if it is happy to allow foreigners to build up a huge mass of
claims on its assets—and if foreigners are happy to go along,Some economists watch with
consternation as the rest of the world's claims on America outstrip America's claims on the rest of
the world,As they point out,even a dollar bill is an American liability,a promise of ultimate
payment by the US Treasury,Can America keep making these promises to foreigners,without
eventually emptying them of value?
According to Mr Davidson,the world cannot risk America stopping,America's external deficit means
an extra $500 billion is going into circulation in the world economy each year,If America reined in
its current account,international commerce would suffer a liquidity crunch,as it did periodically
under the gold standard,Hence America's deficit is neither a,meaningless concept” nor a
lamentable drain on world savings,It is an indispensable fount of liquidity for world trade,
Spigot by nature
But is the deficit sustainable? Many of America's creditors,Mr McKinnon argues,have a stake in
preserving the dollar standard,whatever the euro's potential charms,In particular,a large share of
America's more liquid assets are held by foreign central banks,particularly in Asia,which dare not
offload them for fear of undermining the competitiveness of their own currencies.,Willy nilly,” Mr
McKinnon says,“foreign governments cannot avoid being important creditors of the United States.”
China,for one,added $60 billion to its reserves in the year to June by ploughing most of its trade
surplus with America back into American assets,
This is not the first time America's external deficits have raised alarm,In 1966,as America's post-
war trade surpluses began to dwindle,The Economist ran an article entitled,The dollar and world
liquidity,a minority view.” According to this view,the build-up of dollar claims by foreigners was
not a,deficit” in need of,correction”,Rather,the American capital market was acting like a global
financial intermediary,providing essential liquidity to foreign governments and enterprises,In their
own ways,Mr Davidson and Mr McKinnon echo this minority view today,A,correction” of America's
current deficit,they say,would create more problems than it would solve,Whether the world's
holders of dollars will always agree remains to be seen,
“Financial Markets,Money and the Real World” by Paul Davidson,Edward Elgar 2002,
“The International Dollar Standard and Sustainability of the U.S,Current Account Deficit” by Ronald McKinnon 2001,Available on
www.stanford.edu/~ mckinnon/papers.htm
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