Fiscal Confrontation And The Declining Influence Of The United States

By Simon Johnson

It is axiomatic among most of our Washington elite that the United States cannot lose its preeminent global role, at least not in the foreseeable future. This assumption is implicit in all our economic policy discussions, including how politicians on both sides regard the leading international role of the United States dollar. In this view, the United States is likely to remain the world’s financial safe haven for international investors, irrespective of what we say and do.

Expressing concerns about the trajectory of our federal government debt has of course become fashionable during this election cycle; this is a signature item for both the Tea Party movement in general and vice presidential candidate Paul D. Ryan in particular.

But the tactics of fiscal confrontation – primarily from the right of the political spectrum – only makes sense if the relevant politicians, advisers and donors firmly believe that the American financial position in the world is unassailable.

Threatening to shut down the government or refusing to budge on taxes is seen by many Republicans as a legitimate maneuver in their campaign to shrink the state, rather than as something that could undermine the United States’ economic recovery and destabilize the world. This approach is more than unfortunate, because the perception of our indefinite preeminence – irrespective of how we act – is at completely odds with the historical record. In his widely acclaimed book, “Eclipse: Living in the Shadow of China’s Economic Dominance,” Arvind Subramanian places the rise of the dollar in its historical context and documents how economic policy mistakes, World War II and the collapse of empire undermined the British pound and created space for the United States dollar to take over as the world’s leading currency. (Dr. Subramanian and I are senior fellows at the Peterson Institute for International Economics; we have worked together, but not on this book.)

Very few people in Washington are aware – and even fewer care – that persuading people around the world to hold both their official government reserves and their private wealth in dollars was the result of a hundred-year process and a great deal of hard work. Responsible economic policy and being careful about its fiscal deficit were absolutely part of why the United States persuaded others that holding its dollars was appealing.

But Dr. Subramanian also asserts that two other factors were important: the sheer size of the American economy, which overtook Britain’s, probably at some point in the late 19th century, and the United States current account surplus. In particular, American exports were far larger than imports during World War I and by the end of World War II the United States had amassed almost half the gold in the world (gold at that time was used to settle payments between countries.)

In effect, the United States dollar pushed aside the British pound in part because the United States became the world’s largest creditor.

Dr. Subramanian’s point is not just that the United States will lose its predominance but rather that it has already lost key advantages. The United States has run current account deficits consistently since the 1980s; we are now the world’s largest debtor, not a creditor. About half of all federal debt is held by foreign individuals and governments. Emerging markets have amassed very large foreign-currency reserves (much of which is this Treasury debt in dollars).

The Chinese are embarked on a long-term strategy to make their currency, the renminbi, into an appealing reserve currency. Their economy is currently between one-quarter and one-third the size of the American economy, but it is catching up fast. You may not agree with Dr. Subramanian on the extent of Chinese dominance today, but there is no question that this is a real possibility within 20 years.

The “fiscal cliff” coming at the end of this year could be resolved in a reasonable manner (if you need a primer on what is coming, I recommend these graphics from NPR’s “Planet Money.”) For example, let the Bush-era tax cuts expire and replace them with other temporary tax cuts (e.g., to payroll taxes), to provide short-term support to the economy. And American politicians could find other ways to restore federal government revenue to where it was in the late 1990s while also bringing health-care spending under control.

The point is not to make precipitate adjustments but rather to increase revenue and limit spending in a reasonable manner over the next two decades.

But this is not going to happen. Congressional Republicans will refuse to consider anything they regard as a tax increase, and the fiscal cliff is likely to become a repeat of the debt-ceiling fight last summer, which ended up making everyone in Washington look bad. What would be the consequences?

First, this will definitely be destabilizing to world financial markets – making people more concerned about risk both in the United States and around the world. Anyone who pays a “risk premium” when they borrow – including American home buyers and euro-zone governments – is likely to be affected negatively. Uncertainty and fear will increase, slowing the economy in the United States and perhaps contributing to yet another round of crisis in Europe. The stock market will presumably fall.

Second, yields (market-determined interest rates) on United States Treasury debt are likely to fall. In most other countries, when politicians act irresponsibly, bond yields go up. But we are still the world’s No. 1 safe haven – so capital will come into the United States. Some politicians will see this as justification for their tactics.

Third, Dr. Subramanian will be proved right, faster than would otherwise be the case. The world will more eagerly seek an alternative to the fickle American dollar. It will become increasingly hard for the United States to borrow at reasonable interest rates.

The dollar became strong because American politicians were responsible, careful and willing to compromise. Fiscal extremism, confrontation and a refusal to consider tax increases over any time horizon will undermine the international role of the dollar, destabilize the world and make it much harder for all of us to achieve any kind of widely shared prosperity.

An edited version of this post appeared recently on the’s Economix blog; it is used here with permission.  If you would like to reproduce the entire column, please contact the New York Times.

26 thoughts on “Fiscal Confrontation And The Declining Influence Of The United States

  1. Tax cut reductions via FICA is a terrible idea, because it weakens the financial position of Social Security, one of the main targets of right wing pols, and viewed with envy by those Wall Street mugs who want more privatization of the commonwealth.

    Wrong-headed republicans in the District Of Criminals won’t be satisfied unless and until their wrong-headed ideas succeed in blowing up not only this economy, but that of the rest of world dependent on the US dollar.

    I basically am in agreement with Simon’s post, especially the final summarizing paragraph.

  2. “The world will more eagerly seek an alternative to the fickle American dollar. It will become increasingly hard for the United States to borrow at reasonable interest rates.”

    The above quote confuses me. If the world continues to sell things to the US and those transactions are conducted in dollars, then the seller ends up with dollars. I see three choices here for the seller with dollars. 1) stuff the dollars in a mattress or 2) buy US goods/services to send the dollars back to the US or 3) buy US treasuries that earn interest.

    2 is always a possibility, but likely to take a long time to turn the tide against our large account deficit. 1 is silly because 3 at least earns interest. So barring an increase in desire for US goods/services, wouldn’t a rational seller who has a pile of dollars choose 3?

  3. Peter, Paul, and the dollar. What is money,or gold, it’s not the dollar, not even close. You see money as a unit of time, trumps all other forms of it. Gold is the same way, but the dollar will shine and stink until there is no other. No other freedom that is, because the chains that bind the dollar, also bind lady liberty. And she won’t quit until her day is done.

  4. Joel, the problem with your analysis is that people will eventually quit taking dollars for our purchases. They used to prefer the British Pound, for example, but their current account deficit became too large. Sellers began to demand dollars. Eventually, they will begin to demand renmimbi. They don’t have to take dollars just because we have them. When they flood the market, they become less valuable and no one wants them.

  5. Truman, please correct me if I’ve misunderstood, but the way I see things is if/when China (or any net-exporter-to-the-US) stops taking dollars from us, then their economy takes a massive hit (relative to the size of their exports). Granted, our standard of living will drop because we wont have all those cheap Chinese made goods, but it’s not like China is going to be in great shape either. From what I can tell, China’s exports to the US as a percentage of their total exports is around 25%.

    There’s also the issue of China not being able to manipulate their currency without a large amount of US dollars.

    If sellers do start demanding renmimbi, we have to go acquire them by selling goods/services for renmimbi which reduces our account deficit, no? That, or we stop buying things denominated in renmimbi, and start making things in the USA again.

    My guess as to why the dollar overtook the British Pound was due to the Bretton Woods agreement where all currencies were tied to the US dollar. I do have to read the book referenced here to hopefully learn more about this.

    US influence will decline, no doubt, as other countries grow, but China demanding renmimbi, or India rupees, Brazil reals, etc. doesn’t worry me so much. Maybe I should…

  6. its always good to be friends with the biggest bully in the playground … that’s why english-speaking nations, and a handful of others, like being friends with the USA, period. its better than the alternative and who actually trusts China !

  7. Implicit to this argument is the explicit fact that economic monetary domination and supremacy are inherent to the global world and the balance of power stability is perceived as holding power over this competitive advantage.

    The same is true in the Domestic economy but the demarcations of “class structured” and nested hierarchies are left out of the equations that determine the inclusive and exclusive thresholds of tolerance. It is easy to polarize the national entities and competing continents…it is less obvious when Wall Street, Private Equity and Hedge funds take the same magnitude of power influences over the domestic economy and its distribution of liquidity …as well as controlling interests that emerge over asset grabbing stealth.

    Path dependency for sustaining institutional magnitudes are not based upon creating scale (past formulas taken into account) as much as these produce hierarchical revenue demands for survival and compulsive strategies in an ongoing dynamic / hostile environment of changes. In the zero sum game of continuous straining supremacy, progress and maximizing demands oppositional regression, reduction and minimizing towards an eventual competitive disadvantage and ultimate exclusion.

    This is true attacking and containing labor as a “threat” to wealth as well as seeing China as the new cause for both containment and competitive restraints. The truth of the matter is that China is now playing the same game that we have advocated as the best system…that is capitalism. Unfortunately, they are also learning it from us and the power of political / polarizing economics is now in game theories playbook until we learn to open the globe to all humanity…and stop having elite minority sub-groups of absolute power dictate to all of humanity as the final (containment) solution repeated ad nauseum to a fear driven majority.

    Meanwhile this “foreign policy” mirage is a distraction from what the power money is doing to the domestic USA…YOU and ME! Right here; Right NOW>>>>>!

    “One of the themes that Governor Romney has been hitting at aggressively in his campaign ads is that he will get tough on China. The ads complain that China is a cheater, most importantly by “manipulating” the value of its currency. This means that China has been deliberately keeping down the value of its currency against the dollar.”
    from Dean Baker October 2, 2012
    Cracking down on China means cracking down on Mitt Romney
    Real-World Economics Review Blog

  9. Now the playing field is becoming multidimensional and has many more moving parts then meets the eye. The questions compound with the interplay of both the Euro and the Petrodollar, …the currency interests in supremacy and reserve status in the carry trades and tripping points to a very edgy “freeze market” neo-conservative stalemate which is slobbering at the mouth to install a process of “shorting” upon the Chinese currencies.. and just for good measure add in the anarchist market scenario of grab bag ethics and capital flight morality…and we end up on the global hedging line of economic hegemony, while contemporary monetary theorists are leading the blind with claims of a “decline” (what freakin decline? We own the globe!).
    This is just a new political awakening of a decade old loaded gun that seeks leverage over China’s growth rate to take a share for itself…just like it does everywhere else in the world!
    China: A Tale of Three Swan Songs
    by: Dian L. Chu March 26, 2010
    “The United States, the European Union and others have long been critical of China’s renminbi / yuan regime. Many U.S. lawmakers complain China’s currency is undervalued by as much as 40% and undercutting the competitiveness of U.S. products.
    Internationally, China is under growing pressure–especially from the United States–to appreciate the value of the yuan. Chinese leaders contend that the yuan’s role in trade balance is limited, and asked nations to loosen the restriction on the import of products instead.”
    and while there is a great deal more; this article has substance to consider as well:
    Why the U.S. Has Launched a New Financial World War — and How the Rest of the World Will Fight Back
    By Michael Hudson, CounterPunch
    Posted on October 12, 2010
    What is to stop U.S. banks and their customers from creating $1 trillion, $10 trillion or even $50 trillion on their computer keyboards to buy up all the bonds and stocks in the world, along with all the land and other assets for sale in the hope of making capital gains and pocketing the arbitrage spreads by debt leveraging at less than 1 per cent interest cost? This is the game that is being played today.
    Finance is the new form of warfare –

  10. ” (what freakin decline? We own the globe!)….”
    I should say that US based Corporations and their foreign financed mixed ownership own the world or are in the process of hostile takeover (opps…private equity investments)…of capital markets (previously known as colonial interests).

    If the USA is in decline as a national people, it is due not to China but to the off-shore petro-dragon corporate hegemony that runs the political economy …to the detriment of our domestic economy.

    CHINA IS SIMPLY THE NEW SCAPEGOAT to blame for our neo-conservative ownership society and its remedies of austerity.

  11. Joel, the problem is that you are only thinking as a US citizen. Every country in the world pays for commodities in US dollars. Australia, Canada, Saudi sell some commodities to China, they all get paid in US dollars. This is huge, and why China has been working out small currency deals with many countries, think they are all currently under $100 billion. It`s the first step in what they hope will be the elimination of the US dollar for most of their commodity purchases.

    Of course China might be happy everything is priced in US dollars, makes it easier to spend them :)

  12. Simon,
    I’m a huge fan and have followed you for a long time. But one common economic error that seems to consistently occur during the political jousting between left and right is that the US will have some sort of a problem with default or interest rates on its debt in the future.

    This is not possible since the US issues its own currency and that its debt is denominated in that currency. The interest rate on our debt is simply a way for the fed to control monetary policy at the bank level. The Fed SETS interest rate targets for economic/political reasons and has complete control of it ( down to 0) as it can simply print money at any time to retire debt when desirable (remember, both money and bond, bills, etc are ALL debts of the US government). For this reason the US can never have a crisis of debt or interest rates on its debt. The only REAL risk to the US is inflation from printing too much money at FULL EMPLOYMENT.

    Since we are currently in a Deflationary Debt Spiral with large current unemployment, the real problem is not enough money at the base purchasing level (failure of wages to keep up with economic expansion over the last 30 years), requiring an EXPANSION of government monetary policy NOT a contraction of monetary policy by retiring the US debt. This is simple Keynesian economics, and largely agreed on by even right leaning economists.

    This hysteria about the national debt seems more like a smoke screen for the right in an attempt to undermine the current administrations only possible way to restore the economy to full employment. Unfortunately, Obama seems to have fallen into the fallacy himself, and now argues FOR reduction of spending at the worst possible time .

  13. The soon to be hysteria about the national debt is real, as are personal debt and unfunded liabilities. Just the national debt alone would take every working person one year of parts and labor to bring to a zero level, that’s only your share of the gvt spending. The citizens owe almost 4 times more personal debt, and the very near future requires about 2 and a quater times the personal debt. This comes home to roost in the form of price inflation, meaning things cost more to buy and therefore taxing the lower classes who’s money does not extend as far as it did the day before.

    Like minded people rarely choose the more efficient method because it brings in less money to financial crowd and that is what their idea of capitalism is. The answer to all debt problems is controlling interest rates and of course growth, it has always been the republican mantra and politicians in general. They use the term so frequently it becomes second nature to them because it has worked so many times in the past and and always promises to do so in the future. But the fatal political mistake was in thinking that it works for every scenario, it does not. And when it does not, the gvt revenue drops and more borrowing must take place to fill in the financial gaps or find spending cuts.

    We reached that stage in 08, and ever since then the costs of growing the economy have risen due to foreign country’s competing with so many of our dollars. But the political message remains the same, the financiers are going to grow the economy by lowering tax rates here and financing global growth. It might look okay for the future books , but the loss of the efficiency factor only privatizes the profits and socializes the losses as it now shrinks the middle class and places more money in fewer peoples hands. And since it works for those few people, it is considered a success and laws are made to enforce it.

    It was reiterated again last night as Romney refuses to increase taxes on the upper class, insisting that it would stunt growth, and his only answer was to lower the tax rates on small business in public, and to repaitriate the corporate foreign profits behind closed doors.

  14. Keynes was wrong. There is no direct correlation between interest rates and full employment. The Fed’s directive to promote full employment and keep prices stable is nonsensical. Continued attempts to lower interest rates (QE) cannot help our economy. We cannot have significant impact on our current account deficit while the Dollar is a refuge currency. Even at 0% interest, our T-bills were being purchased. Better to take a loss from inflation than a hit to principle. The commodities modernization act and the actions of the Fed have caused significant inflation regardless of the reports to the contrary. The attempts to cheapen the dollar to repair our current account deficit have raised prices for all Americans and created huge sums for hedge funds using cheap debt to push the prices of commodities through the roof. It has also led to the expanding chasm between the rich and everyone else. Commodity prices grew at around 10-15% pre-“modernization” and 270% post “modernization”. The presidential bickering about federal spending simply distracts from the real issue – Bernanke is wrong. A stronger dollar would lower import costs for all, raising the standard of living, middling interest rates would help support retirees on fixed incomes and encourage saving. The trouble now is how to unwind our addiction to cheap money.

  15. The trouble now is how to unwind our addiction to cheap money.

    A truer word has never been as well stated as that one.

    I’ll chase um down.

  16. Mike:
    Do you have any information on how similar economies with the U.S.’s special powers have done in the past?
    You certainly seem to make a case of the positive side of the U.S.’s special economy. But you and many others seem to downplay the negative side.
    Every act, no matter how large or small, has positive and negative effects. If this power to print money is so crucial to our recovery, then it must have huge positive side effects. If that is the case, it mist have huge negative side effects.
    Don Levit

  17. As the financial elite gets more elite in dollar size and percent of available accumulation their definition of AMERICA changes. It is all about protecting their position, monetarily and personally.

    One little mans opinion.

  18. Hi Don,

    As I mentioned in my previous comment, the down side of being able to print currency (and particularly the reserve currency of the world) revolves around inflation. When too much money is available AT HIGH EMPLOYMENT LEVELS (and high economic production levels & adequate resources), inflation is the outcome.

    Right now, with large unemployment, the issue of real inflation is negligible since at less than full employment, the economy can continue to supply more goods and services than it is producing right now- sopping up the excess dollars that are produced. At high employment levels (and high output/production levels), the excess dollars would cause a dwindling supply of goods and services and high demand from all the employed people to cause inflationary pressures on pricing. Econ 101-

    Debt created by the US Govt is an economic tool that allows the US Govt (read the Fed) to control interest rates in the economy. Think about it, the Sovereign has the right to print money at any time it chooses, why would it need to borrow anything. For political reasons in the past the US Govt decided to use an economic system which split its creation of money into both currency and debt instruments. This allows the Fed to control interest rates in the economy through the use of the overnight inter-bank lending interest rates and the bank reserve system- Voila, the ability to use monetary policy (the setting of that overnight rate) to control interest rates in the economy. The debt that is created can be retired at any time printing money, but with many negative effects if not done in an orderly way.

    Debt levels of the size created by the US now have been done before- the end of the depression into WWII, and when full (High) employment rates were once again established and the war ended, the production of real goods and services (butter not bullets) the deficit was reduced at a reasonable rate to a level consistent with good economic balance. This is what Keynes bases his theories on.

    The Japanese have run deficits over twice as much as we are targeted to reach for over a decade (percentage wise) with negligible down sides. On the other hand, if THEY had tried to reduce their debt levels using austerity type programs, production would fall, unemployment would rise even higher and the deficit would increase to an even higher level with no benefit to the Japanese society. We face exactly the same problem Japan created in the late 1980’s.

    I have yet to find any real world example of a large economy that creates it’s own currency that has not followed Keynes models. If you have a real world example of an economy that has worked counter to those theories, I am very open to reviewing that example!

    Today, for us, the only way out of our current situation is a very large stimulus (yes, two to three times the one we tried before), not created by a very large war (today, a large war would completely destroy the very basis of production). Although the deficit will rise considerably the return to high employment that deficit will be returned to comfortable levels within a few years through increased taxes from the expanded economy the same as happened after WWII.

    However, with the current capture of our political system by unrestricted money thrown at our politicians by the 1% (really the .1%), the stimulus will not be forthcoming, and lies, like the hysteria about the national debt, will continue to cloud the real issues, both economic and political.

  19. Mike:
    Thanks for your reply.
    I agree with you that inflation does not seem to be a problem at this point.
    You wrote that with high unemployment, the economy can supply more goods and services, sopping up the excess dollars.
    You seem to suggest that the demand for goods and services is there, we just do not have enough dollars that necessitates the extra production.
    So, what are we supposed to do?
    With the ability to print money, should we issue a $2,000 check to every family who makes less than $50,000 a year, so they can afford what they, apparently, really need?
    What type of stimulus are you suggesting?
    Don Levit

  20. Re the negative side. If you look at it what took the UK down was two wars of national survival, WWI and WWII. After WWII the UK was essentially bankrupt because of the war. The UK economy was hurt by politicians (particularly Churchill as Chancellor of the Exchequer who felt that WWI had not changed the situation and Britian did not need to devalue its currency) When it did so in 1931 the depression in the UK got better (After the central bankers got off their gold fetish) See Lords of Finance for details.

  21. Hi Don,

    As you suggest, demand is ALWAYS there, but not necessarily capable of expressing itself.. Its intuitive that we would all like more money to buy more things, and like wise corporations and state governments (no capability to print money) would like to purchase more goods and services. So the answer to stimulating the economy is to put more money in their hands and they will do the rest- buy goods and services.

    Taxes are an interesting addition to Modern Monetary Theory (MMT), since the govt can print as much money as it wants, then there is really no need for taxes to create currency to purchase goods and services, instead, taxes are used to create space in the economy for the govt to spend WITHOUT creating inflation. In other words, if the govt didn’t take some money out of a balanced economy and continued to spend, the outcome would be inflation. But, as is the case today, with low employment and under utilization of the tools of production, lower taxes will stimulate the economy to increase demand, etc., etc.

    The type of tax reduction, however, is important, as it should target the portion of the economy that will spend the additional money, not save it. Most Economists accept that the payroll tax is the best target for these reductions. The normal worker in our system is most likely to spend the additional money. Since income taxes are payed mostly by the top earners in our economy, the income tax is a poor place to stimulate the economy as these players normally have sufficient money to cover normal day to day expenses and are far more likely to save the income. Many, many workers do not pay taxes since they make less than the minimum required income to pay any tax at all and hence little of the tax reduction would be saved. This is why the payroll tax was targeted for the last stiulus effort, it just wasn’t enough.

    Randy Wray, Professor of Economics at the University of Missouri is an expert in MMT. He believes the Govt should create a program like the one used in the Great Depression to create jobs for anyone who wanted to work. This program would create a employer of last resort for the economy and would not compete with private sector employers as the wages would set a floor for wage and benefits. As the economy recovers, employers would hire away these workers at a higher wage and the program would be self regulating. The program would offer a minimum wage level that would allow a family to live on and medical and retirement benefits at the minimum level. You can look him up on line- quite a few YouTube and blog references.

    I hope this answers your question-

  22. When the USA embarked on its quest to unseat Great Britain as the number one economy in the world it grew from within! US corporations based in the USA were the engines that drove the change. The US companies could get most of the needed raw materials from the USA as well as energy, the USA was nearly totally indpendent of imports of any kind especially food! China is dependent on imports on energy and food, to mention only two essential resources, for which it has to pay ever higher prices. Take away the Western companies from China and what have you left? An empty shell with factories as empty and silent as graveyards at night!

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