The Demise of the Dollar?

Since the early 1980s, the United States has been the major destination for foreign goods on a global scale. With an increasing part of these imports being financed by debt creation, the international monetary system has been swamped with liquidity. A financial bubble has emerged and penetrated each corner of domestic and international financial markets.

The funding of the US economy by foreign investors enabled the U.S. to spend rather freely. The United States could act as the global borrower and as the international lender of the last resort at the same time. This way, the role of the United States as the main provider of international liquidity has been perverted and an unsustainable situation has emerged.

The net external investment position of the United States now is negative at more than two trillion US dollars. With the absence of private savings and growing government deficits, the need of external financing is growing. Whatever may be the appropriate political reasons for the US government's new geo-strategic aims, economically the consequences will be a cost push, and the risks are mounting that the U.S. will be headed for an economic and financial disaster when foreign funding of its expenditures should collapse.

The current global financial system is tilted towards favoring excessive absorption by the United States as it shows up in the current account imbalances (see table 1). For some time, a structure like that is highly beneficial for the economy, which has the privilege of providing international liquidity. The country that issues the global currency gets a free lunch as long as its debt certificates serve as international means of payments. At some point, however, the system must necessarily go into reverse, when the discrepancy between the issue of debt and the productive capacity becomes too large.

Current Account Balances in Major Regions 1997–2002 (in billions of US dollars)

(*) Forecast

Various factors are already in place and gaining force that will contribute to reverse the past pattern of international capital flows. While the U.S. is entering a phase of growing financial burden due to increased security expenditures and unilateral transfers, the provision of funds from abroad tends to diminish, making it difficult for the United States to finance its global aspirations.

Japan, which has long been the principal source of financing for the US current account, provided around 100 billion US dollars annually in order to compensate part of the record American deficits of more than 400 billion each year since 2000. In the long run, given Japan's precarious state of government finances and the advanced stage of the ageing process of its population, it seems rather unlikely that Japan will be able to continue providing funds at such a large scale for years to come.

Emerging Asia, with China as the most prominent economy in this group, has registered current account surpluses of almost 100 billion US dollars in the past years up from 20 billion US dollars in 1997. In China, domestic needs are already surging more urgently making it more likely that China must shift to higher imports for such items as oil and food.

The contribution of the European Union in terms of current account surpluses, which was more than 107 billion in 1997, is already in decline and will probably stabilize at around zero. In terms of long-term capital movement, the Euro Area provided a combined contribution to global financing by exporting capital amounting to 347 billion US dollars from 1999 to 2001 during a period when the United States absorbed a total of 1.3 trillion US dollars from abroad (see table 2).

Like Japan, the major European capital exporting countries are facing an avalanche of rising social costs due to an ageing population. Furthermore, the expansion of the EU to the East will redirect trade and foreign direct investment from the United States to Eastern Europe and to other world regions.

Net long-term capital flows 1999–2001 (in billions of US dollars)

(A minus sign signifies capital export.)

The relative strength of the US dollar in the past couple years reflected in large part the massive capital inflows that came to the United States from abroad. The United States experienced a benign circle where foreign capital for direct investment was attracted by the high growth rates when these inflows in turn contributed to create the superior rates of economic growth. Additionally, the massive external financing of US bond sales—424 billion US dollars alone in 2001—helped to keep US long-term interest rates low. The huge imports of foreign goods, which amounted to 452 US dollars in 2000 and to 427 billion US dollars in 2001 (see table 3), have kept down the domestic price level thereby contributing further to lower interest rates and higher real growth.

US Current Account (1999–2001) in billions of US dollars

The United States, due to its unique position as the provider of the leading world currency, has been able to largely immunize itself from the immediate consequences of a global contraction which is already strongly felt at the periphery of the global financial system. However, a shift or retraction of international capital flows; i.e., a repatriation of assets out of the United States and back to Japan, Europe and other foreign creditors, would affect the international payment ability of the United States in a direct way because it would imply a weakening of the US dollar and probably lead to higher interest rates. Consequently, the US economy would face a severe economic downturn.

Given the trend that the US net investment account is worsening while at the same time there will be rising government deficits and increasing current transfers, the future role of the US dollar appears problematical. Up to now the dollar could maintain its value due to its undisputed position as the dominant international currency. This privilege, however, does not imply that the international credit capacity of the United States would be unlimited. With alternatives sought for and emerging—such as the euro or the plans of a gold-based international currency—the dollar's global role becomes increasingly vulnerable.

The consequences of a markedly diminished position of the US dollar would be dramatic and of global proportions. While it would affect all economies that are closely related to the US economy, the major impact would fall on the United States itself. A demise of the US dollar as the dominant global currency would mean that the current relation between domestic absorption and production could no longer be maintained. Given the time and difficulties it takes to build up adequate production capabilities the immediate response would necessarily fall on private demand.