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 NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.