Dollar Crisis: Prospect and Implications
Dollar Crisis: Prospect and Implications
Updated May 6, 2008
Craig K. Elwell
Specialist in Macroeconomic Policy
Government and Finance Division
Dollar Crisis: Prospect and Implications
The dollar’s value in international exchange has been falling since early 2002.
Over this five year span, the currency, on a real trade weighted basis, is down about
25%. For most of this time the dollar’s fall was moderately paced at about 2.0% to
between January and December of 2007. An acceleration of the depreciation brings
the periodic concern of an impending dollar crisis to the fore. There is no precise
demarcation of when a falling dollar moves from being an orderly decline to being
a crisis. Most likely it would be a situation where the dollar falls, perhaps 15% to
20% annually for several years, and sends a significant negative shock to the U.S. and
the global economies. A crisis may not be an inevitable outcome, but one that likely
presents considerable risk to the economy.
The large U.S. current account deficits are sustained by an inflow of foreign
capital. That inflow also exerts upward pressure on the value of the dollar as
investors demand dollars to enable the purchase of dollar denominated assets. There
is a limit to how much external debt even the U.S. economy can incur. Erasing the
U.S. trade gap would stop the accumulation of debt. This would occur through a
rebalancing of global spending, composed of a decrease of domestic spending in the
United States and an increase of domestic spending in the surplus economies. Such
shifts in domestic spending patterns must be induced by a depreciation of the dollar,
causing the price of foreign goods to rise for U.S. buyers and the price of U.S. goods
to fall for foreign buyers.
The critical factor governing whether orderly and disorderly adjustment of
international imbalances occurs is foreign investor expectations about future dollar
depreciation. Rational expectations will have a smoothing effect on the size of
international capital flows. In contrast, a sharp plunge of the dollar is likely to occur
if investors do not form rational expectations. If the dollar then depreciates at a rate
faster than foreign investors now expect, a dollar crisis becomes likely. Currently
foreign investors do not appear to have a realistic expectation of future dollar
depreciation. A dollar crisis could start when they realize their error and try to move
quickly out of dollar assets — the likely stampede would cause a “dollar crisis.”
Three prominent counter-arguments to the dollar crisis prediction (the global savings
glut argument, the Bretton Woods II argument, and the economic dark matter
argument) do not offer credible alternatives to the dollar crisis outcome.
The transition to a new equilibrium of trade balances may not be smooth, likely
involving a slowdown in economic activity or a recession. The ongoing U.S. housing
price crisis raises the risk of a dollar crisis causing a recession. With fiscal policy
most likely out of consideration in the near term, the task of attempting to counter the
short-term contractionary effects of a dollar crisis would fall upon the Federal
Reserve. A stimulative monetary policy can be implemented quickly but its eventual
effectiveness is uncertain. The most useful policy response by foreign economies
would be complementary expansionary policies to offset the negative impact of their
appreciating currencies on their net exports. Attempts to defend a currency against
this crisis driven appreciation would be costly and likely fail.
In troduction ......................................................1
Anatomy of Dollar Crisis............................................2
Possible Reasons Why A Dollar Crisis Won’t Occur......................6
Global Savings Glut............................................6
Bretton Woods II..............................................7
The Macroeconomic Effects of a Dollar Crisis..........................10
The Response of Economic Policy...................................11
Response of U.S. Economic Policy...............................11
Response of Foreign Economic Policy............................13
Prospect and Implications
The dollar’s value in international exchange has been falling since early 2002.
Over this five-year span, the currency, on a real trade-weighted basis, is down about1
25%. This depreciation has been orderly so far. For most of this, time the dollar’s
fall was moderately paced at about 2.0% to 5.0% annually. Recently, however, the
slide has accelerated, falling over 9.0% between January and December of 2007, but
falling faster over the last four months than during the previous seven months. For
the first three months of 2008 the dollar has fallen another 2.9%
An acceleration of the depreciation brings the periodic concern of an impending
dollar crisis to the fore. There is no precise demarcation of when a falling dollar
moves from being an orderly decline to being a crisis. Most likely it would be a
situation where the dollar falls, perhaps 15% to 20% annually for several years, and
sends a significant negative shock to the U.S. and the global economies. This crisis
may not be an inevitable outcome, but one that likely presents considerable risk.
That negative shock will likely lead to some degree of slowing of economic
activity. For the U.S. economy, already weakened by the ongoing housing price
crisis, a further dampening effect caused by a plummeting dollar would significantly
raise the risk of recession. For the rest of the world, the impact would also depend on
what else was going on in their economies at the time of the dollar’s fall. It is likely
that the negative impact would be substantial for foreign economies that are highly
dependent on export sales to the United States. 2
This concern about the dollar’s near-term path raises three questions: (1) will
a dollar crisis occur? (2) what macroeconomic impact might a dollar crisis have on
U.S. economy, and the world economy? and (3) are there policy responses that can
counter adverse impacts?
1 The trade-weighted exchange rate index used is the real broad index reported monthly by
the Board of Governors of the Federal Reserve System.
2 For an early treatment of the dollar crisis scenario, see Stephen Marris, Deficits and The
Dollar: World Economy at Risk, Institute for International Economics, Washington DC,
Anatomy of Dollar Crisis
The large U.S. current account deficits are sustained by an inflow of foreign
capital. The necessary counterpart for this inflow to occur is economies in the rest of
the world that generate capital outflows and run trade surpluses. The country with a
trade deficit is an international borrower and is accumulating external liabilities. The
economies with trade surpluses are international lenders and accumulate external
The capital inflow to the United States also exerts upward pressure on the value
of the dollar as investors demand dollars to purchase dollar denominated assets. The
upward demand pressure on the value of the dollar is pulling against the downward
pressure on the dollar exerted by the large supply of dollars pumped into the foreign
exchange markets by the U.S. trade deficit. From the mid-1990s until early 2002, the
strength of foreign demand for dollar assets was sufficient to keep the dollar
appreciating despite the rapid expansion of the trade deficit in this time period. Since
2002, however, although the United States continued to receive a rising inflow of
capital, the strength of the associated demand for dollars has not been sufficient to
prevent the dollar from depreciating moderately under the weight of large current3
account deficits in this time period.
This external financing of the U.S. current account deficit has occurred with
relative ease so far. But large scale borrowing can not go on indefinitely. There is a
limit to how much external debt even the U.S. economy can incur. Currently, the
U.S. debt/GDP ratio is at a historical high of about 19.2%. It is uncertain how much
higher this ratio can go, but most economists would argue that there is an upper
bound and at some point the US. trade deficit will need to be closed to stabilize the
level of external debt at a feasible level.
Erasing the U.S. trade gap will require a rebalancing of global spending. A trade
deficit is a symptom of an economy that spends more than it produces; therefore,
rebalancing requires a decrease of domestic spending in the United States. In
contrast, a trade surplus is a symptom of an economy that spends less than it
produces; therefore, rebalancing requires an increase of domestic spending in surplus
economies. These shifts in domestic spending patterns can be induced by a decrease
in the price of U.S. goods and services relative to the price of foreign goods and
services. For the change in relative prices to happen the dollar must fall, causing the
price of foreign goods to rise for U.S. buyers and the price of U.S. goods to fall for
foreign buyers. In addition to the downward pressure on the dollar of the large trade
deficit, an important animating force in this adjustment would likely be a reduction
in the demand for dollar denominated assets by foreign investors and a shrinking of
the associated capital inflow.
3 For a more extensive discussion of international asset flows and the trade deficit, see CRS
Report RL31032, The U.S. Trade Deficit : Causes, Consequences, and Cures, by Craig K.
This rebalancing of global spending does not have to be disorderly and
disruptive. The major depreciation of the dollar that followed the breakup of the
Bretton Woods international monetary system in the early 1970s was largely orderly.
More recently, the protracted fall of the dollar and reduction of the U.S. trade deficit
in the late 1980s and early 1990s was also an orderly adjustment of international
Why might a disorderly adjustment and dollar crisis occur? The critical factor
is foreign investor expectations about future dollar depreciation. Economic theory
indicates that a rational foreign investor in deciding whether to hold more or continue
to hold his current dollar assets will build into that decision some estimate of future
dollar deprecation. For example, a dollar asset and a euro asset each of similar risk
and each offering a 2% real return would present very different expected returns if
the dollar is expected to depreciate 4% annually and the euro to remain steady over
the holding period. With these expectations, the rational investor would need the
dollar asset to offer a real yield in excess of 6% to make it more attractive then the
euro asset at 2%.
A moderation of market behavior and crisis free adjustment occurs when foreign
investors develop rational expectations about the currency’s future path. Rational
expectations about the dollar’s future path will have a smoothing effect on the size
of international capital flows. In a time of capital inflows, some expectation of
possible future depreciation tends to moderate those inflows. Conversely, in a time
of capital outflows, some expectation of possible future appreciation will tend to
moderate those outflows.
In contrast, a sharp plunge of the dollar is likely to occur if investors do not form
rational expectations about the dollar’s future path. If the dollar then depreciates at
a rate faster than foreign investors now expect, a dollar crisis becomes likely. The
rate of depreciation of the dollar that is rational to expect is the rate which is
consistent with avoiding the accumulation of an unsustainable level of U.S. external
debt. It is, however, difficult to say what that debt level is. Nevertheless, there is a
debt/GDP ratio that prudent economic agents will judge to be an upper bound. Given
that, the question becomes: what rate of dollar depreciation will give a rate of closure
of the trade deficit that contains the debt/GDP ratio below that upper bound?
The economist Paul Krugman has calculated a range of estimates of U.S.
external debt accumulation under alternative rates of convergence of the trade deficit
to balance.4 He assumes, based on the general consensus of experts, that a further
real depreciation of the dollar of about 35% would, at a minimum, be necessary to
close the U.S. trade gap.5 He then considers two rates of convergence to this goal:
one occurring over 20 years with a 1.75% annual rate of depreciation of the dollar.
It leads to an external debt/ GDP ratio of 118%. At that size it is possible that a third
or more of the U.S. capital stock would be foreign owned. The second scenario has
4 Paul Krugman, “Will There Be a Dollar Crisis,” Economic Policy, July 2007.
5 See, for example, Micheal Obstfeld and Kenneth Rogoff, “Global Current Account
Imbalances and Exchange Rate Adjustment,” Brookings Papers on Economic Activity, no.
convergence occurring over 10 years with an annual rate of depreciation of the dollar
of about 3.75%. It leads to an external debt/GDP ratio of 58%, which is more than
twice the size of the current historically high level of U.S. debt/GDP ratio. That
seems high for a large, relatively closed economy like the United States, but, perhaps,
plausible given the current trends in financial globalization.
Guarding against an overly pessimistic outcome, these computations incorporate
significant constraints on the growth of the external dept/GDP ratio. For instance,
each estimate of the eventual debt to GDP ratio assumes that nominal GDP will grow
at an annual rate of 5.5%, with a combination of 3.0% real GDP growth and 2.5%
inflation rate. This could be a slightly optimistic assumption for the pace of real GDP
growth, which has averaged only 2.7% in the current economic expansion. Slower
growth of GDP would make the Debt/GDP ratio climb faster.
Also, Krugman’s external debt estimates take into account the tendency of a
depreciating dollar to improve the U.S. net debt position. This improvement is caused
by favorable valuation effects on U.S. foreign assets. These occur because U.S.
foreign liabilities are largely denominated in dollars, but U.S. foreign assets are
largely denominated in foreign currencies. Therefore, a real depreciation of the dollar
increases the value of U.S. external assets and largely does not increase the value of
U.S. external liabilities. This asymmetry in the currency composition of U.S. external
assets and liabilities results in a dollar depreciation reducing U.S. net external debt.6
Exchange rate induced valuation effects are substantial because they apply to
the entire stock of U.S. foreign assets, valued at near $14 trillion in 2006. The large
scale of U.S. foreign assets means that valuation changes can offset a sizable portion
of the current account’s deficits annual addition to the existing stock of external debt.
For example, in 2006, the current account deficit made a $81l.4 billion contribution
to U.S. external debt. But the total value of net external debt in 2006 increased only
about $300 billion due to an offset of over $500 billion (over 60%); nearly half of
this offset was attributable to positive valuation effects on U.S. foreign assets caused
by the dollars depreciation that year.7 If rapid dollar depreciation causes significant
numbers of future lenders to be only willing to hold nondollar denominated U.S.
debt the scale of the positive valuation effects would shrink and make the debt/GDP
ratio climb faster.
In addition, one could argue that the 35% real depreciation target understates
what is needed to close the current account deficit. For the United States, the
equilibrium exchange rate is probably a moving target, and one whose path has been
uneven but on balance has fallen over the past 30 years. This secular decline is
thought to be rooted in rising technology in emerging economies that has allowed
6 Most countries are not able to borrow in their own currency so a fall of their exchange rate
will tend to increase their net external debt. This was the problem that plagued the
economies caught in the Asian financial crisis in 1997, when their crashing currencies
ballooned their external debt to such a degree that they became insolvent.
7 For further details on net external debt and valuation effects see U.S. Department of
Commerce, Bureau of Economic Analysis, U.S. Net International Investment Position, July
them to generate a steady rise in exports that compete with U.S. tradable goods. It is
difficult to predict the pace of this secular decline, but during the 10- to 20-year
convergence period used in this analysis, it is possible that reaching the equilibrium
exchange rate will require more than the exercise’s assumed 35% real depreciation
of the dollar.
Taken together, these considerations probably give Krugman’s computations of
the implied rise of the debt/GNP ratios a bias toward understatement. Nevertheless,
the scale of the U.S. trade imbalance that needs to be eliminated causes the estimated
ratio to soar in either alternative. If these estimates are understated, then even more
rapid real depreciation would be needed to erase the trade deficit and keep the debt
to GNP ratio below a realistic upper bound.
Based on these computations, Krugman argues that a rational foreign investor
would have to expect the dollar to depreciate by, at least, about 2% per year and very
likely depreciate by 4% per year or more. Do holders of U.S. assets appear to have
taken this probable depreciation into account? It appears they have not. Using
estimates of real long-term interest rates in the United States, the euro area, and
Japan, Krugman finds no difference in real yield between the U.S. and euro area
assets, and about a 1 percentage point advantage for U.S. assets over Japan’s assets.
This lack of a real interest rate spread between dollar assets and similar foreign
assets indicates that investors are expecting virtually no depreciation of the dollar
over the holding period. Therefore, in the face of a seemingly inevitable depreciation
of the dollar at 2% or faster, these investors are holding U.S. assets that offer, in
terms of their own currency, a zero or negative real return.
When foreign investors come to realize their error and try to avoid large capital
loses by moving quickly and substantially out of dollar assets, the dollar will fall
precipitously and the dollar crisis begins. As the dollar’s fall gains momentum there
are likely to be negative interactions with domestic financial markets and domestic
economic activity that will add to this downward momentum, overcoming, for
awhile, the usual corrective mechanisms.
In a dollar crisis, it is unlikely that the current account deficit could decrease as
rapidly as foreign investors would desire to curtail the inflow of capital to the United
States. But the current account deficit will have to be financed. This economic
necessity will generate strong economic forces to assure that the needed economic
adjustments, at home and abroad, occur. The necessary macroeconomic adjustments
will be discussed in a subsequent section of the report. At this point it will be useful
to consider possible counter arguments to a dollar crisis happening.
Possible Reasons Why
A Dollar Crisis Won’t Occur
Over the last few years, several arguments that offer reasons why the U.S.trade
deficit is more sustainable and a dollar crisis less likely than presented in Krugman’s
analysis have received serious consideration in policy discussions about the U.S.
trade deficit and the associated rise of U.S. external debt. This section evaluates three
prominent counterarguments to the dollar crisis prediction: the global savings glut
argument, the Bretton Woods II argument, and the economic dark matter argument.8
Global Savings Glut
Ben Bernanke, now chairman of the Federal Reserve Board, has argued that
there exists outside of the United States a large excess of global saving relative to
global investment opportunities.9 These large and growing flows of foreign saving
are the result of the rapid economic growth of many emerging economies and large
oil earnings by petroleum exporting countries. The IMF estimates that developing
countries had a net capital outflow of about $720 billion in 2006. A large share of
these funds are not going to be used in the home economy and are attracted to U.S.
asset markets because they offer excellent wealth storage services. This service
encompasses the ability of U.S. asset markets to offer a combination of reasonable
rates of return, safety, and high liquidity. The result has been unusually large capital
inflows to the United States.
These inflows of capital have kept U.S. interest rates low and have exerted
strong upward pressure on the value of dollar. It is argued that this saving glut could
continue to grow for many years into the future. Therefore, it will continue to
enhance the sustainability of the U.S. trade deficit and, in turn, provides sustained
and substantial upward pressure on the value of the dollar. This persisting inflow
does not preclude depreciation of the dollar but would moderate the depreciation and
greatly reduce the risk of a dollar crisis.
While the existence of a global savings glut can help explain why the large U.S.
trade deficit has been sustained with relative ease well beyond what many experts
had expected, it does not avoid the looming reality of there being an upper-bound on
U.S. net external debt. And, that this debt ceiling creates the inevitable need for a
large real depreciation of the U.S. dollar. A saving glut can explain why global real
interest rates are low. But it does not avoid the problem posed by those rates being
as low as rates in both the United States, a deficit country, and the surplus economies.
This anomaly occurs because foreign investors in dollar assets are not taking
into account the impending need for a sustained and substantial real depreciation of
8 Paul Krugman, “Will There Be a Dollar Crisis,” Economic Policy, July 2007, also
examines these arguments.
9 See Ben Bernanke, “The Global Savings Glut and the U.S. Current Account Deficit,” the
Sandbridge Lecture, Virginia Association of Economics, March 10, 2005; and CRS Report
RL33140, Is the U.S. Trade Deficit Caused by a Global Saving Glut, by Marc Labonte.
the dollar. When this risk becomes apparent to those investors, they will hurry to find
other destinations for their savings. If that happens, the dollar would plummet.
Bretton Woods II
Some economists have characterized the current global monetary arrangement
as Bretton Woods II (BWII).10 The first Bretton Woods (BWI) was the global
monetary arrangement in place from the end of World War II through 1973. BWI
was a formal system of fixed exchange rates centered on the dollar. Other countries
were obliged to maintain their currencies value relative to the dollar. When needed,
this adjustment was accomplished by foreign central banks buying or selling foreign
exchange to keep their currencies’ value at the fixed parity with the dollar. The
speculative crises caused by relatively free flowing international capital that plagued
the inter-war years were to be prevented by strict controls on the flow of capital
between economies. This system worked reasonably well in the early post-war
period. But accumulating pressure for a major dollar devaluation and increasingly
porous capital controls led to its breakdown in the early 1970s. Since 1973, most
major economies have allowed their currencies to, more or less, float freely on the
global foreign exchange markets, allowing its exchange value to be driven by the
international supply and demand for its goods and assets. Capital controls were also
largely abandoned by these nations.
BWII is not a formal arrangement or organization. It is a de facto arrangement
whereby central banks, particularly in Asia, amass dollar reserves so as to stabilize
their currencies value relative to the dollar. This stabilization is achieved by the
central banks buying dollar assets sufficient to keep their currencies from rising
relative to the dollar. It is also supported by the BWII economies imposing significant
controls on capital flows to and from their economies. Not letting their currencies
rise relative to the dollar enables them to maintain the competitiveness of their
exports in the U.S. market and perpetuate a successful development strategy driven
by export-led growth. China has been a important participant in this arrangement,
with its central bank in recent years amassing well over $1trillion in foreign exchange
reserves, a large proportion being various dollar assets.
With China at its center, it could be argued that because BWII has been a very
successful development strategy for China, and because that country still has over
this de facto monetary arrangement will endure for many more years, and continue
to exert strong upward pressure on the value of the dollar, countering any tendency
towards a dollar crisis.
10 Michael P. Dooley, David Folkerts-Landau, and Peter Garber, An Essay on the Revived
Bretton Woods System, NBER Working Paper 9971, 2003.
However, serious questions can be raised about the stability of BWII.11 One
potential problem is that such large scale accumulations of foreign exchange reserves
can have disruptive macroeconomic and financial effects on the accumulating
economy. To prevent the foreign exchange reserves from causing an unwanted
increase the country’s money supply, its central bank must sterilize the accumulation
of foreign currency assets. It does this by purchasing compensating amounts of
domestic assets which pulls money out of the economy.
Sterilization of dollar inflows on such a large and growing scale, however, will
be an increasingly difficult task for China and other emerging economies. They have
small and immature asset markets that are unlikely to be able to continue to
effectively sterilize further large scale reserve growth. It is likely that this foreign
liquidity will begin to leak into their domestic economy and push up the money
supply. This would, in turn, lead to increased inflation and a domestic lending boom
that generates asset price bubbles. This could cause significant disruptions in their
weak financial markets and adversely affect their economic activity.
In addition, the balance sheets of the foreign central banks that hold large
amounts of dollar assets are exposed to large losses if the dollar crashes. Collectively,
the BWII central banks have an incentive to hold on to their dollar assets to preserve
the value of these holdings. Individually, however, the BWII central banks have an
incentive to sell their dollar assets if they suspect the dollar will soon plunge.
Therefore, the stability of BWII is highly dependent on how much cooperation there
is among these central banks.
Further, a large share of the capital inflow to the United States comes from
private investors whose economic incentives are different than those of the BWII
central banks. Perhaps foreign private investors remain heavily in dollar assets
because they think that BWII can prevent a dollar crash. But there is no strong basis
for such a belief. The efficacy of BWII would be evident if at some point it had
demonstrated an ability to sustain the dollar’s value despite an outflow from the
United States of private capital motivated by realistic expectations about the dollar’s
future falling path. But, what has been occurring are large official inflows along with
large private inflows that are accepting a real return that is insufficient to compensate
for the expected rate of fall of the dollar which realistically must occur.
If BWII is to offset the outflow of private capital based on realistic expectations
of the dollar’s future path, the BWII central banks would need to increase their
already huge dollar reserves by an amount that is probably not feasible. And the
problem posed by there being an upper bound to the U.S. debt/GNP ratio would still
remain. BWII seems unlikely to be seen as a reliable barrier to a plummeting dollar
once foreign investors see the need to adjust to more realistic expectations of the
dollar’s future path.
11 Neil Roubini and Brad Sester, “Will the Bretton Woods II Regime Unravel Soon? The
Risk of a Hard-Landing in 2005-2006,” presented at Symposium sponsored by the Federal
Reserve Bank of San Francisco and the University of California, Berkeley, San Francisco,
Another perspective on the U.S. international balances has been presented by
the economists Ricardo Hausmann and Frederico Struzeneggar.12 It is their
contention that there are large measurement errors in the U.S. trade data that cause
a big understatement of U.S. exports and, in turn, a big overstatement of the size of
U.S. net external debt. In their opinion this error is of a magnitude that the current
account balance has actually been in surplus in recent years and that the United States
is an external net creditor, not a debtor. The principal evidence of this is that despite
a seeming huge net external debt the United States has consistently run a sizable
surplus in the investment income portion of the current account.
The unmeasured exports are not picked up in the export data because they are
are services hidden within U.S. capital outflows. Once abroad, these assets generate
an income stream that is measured as investment income in the current account data.
These invisible assets have been named dark matter because they, like the
astronomical phenomenon, have a visible effect — generating investment income —
that is caused by unseen service exports. It is contented that the dark matter effect is
large. With proper accounting, it transforms a net debt position of about $2.5 trillion
to a net surplus position of about $600 billion.
Three classes of invisible exports are said to exist: global liquidity services,
global insurance services, and knowledge services. The three exports, in turn, are
attached respectively, to three types of capital outflows: U.S. currency, U.S.
sovereign debt, and U.S. foreign direct investment.
Liquidity Services. This service is derived from the U.S. currency’s special
status as a global source of liquidity. A large portion of the $700 billion Federal
Reserve Notes in circulation are held abroad. Estimates of the share vary from a low
of 30% to a high of 70%. The holding of this currency by foreigners is equivalent to
an interest free and irredeemable loan to the United States with an implicit value of
as much as $25 billion.
Insurance Services. It is argued that the world economy uses low-risk U.S.
Treasury Securities to fill out the low-risk end of their investment portfolios. Much
like a global bank, the United States can then use these proceeds to invest in higher
yielding bonds from emerging economies. This amounts to the world exchanging a
risky asset for a safe asset and the yield difference is the equivalent of an insurance
premium the world pays the U.S. for lowering its risk.
Knowledge Services. This service is said to occur because U.S. foreign
direct investment embodies a host of unmeasured assets. These services are in the
form of know-how, brand recognition, expertise, and research and development. This
is the form of dark matter that proponents see as the most important.
12 Ricardo Hausmann and Federico Sturzenegger, “U.S. and Global Imbalances: Can Dark
Matter Prevent the Big Bang?,” (Kennedy School of Government, Harvard University,
Unpublished Working Paper: Cambridge, 2005) and CRS Report RL33570, U.S. External
Debt: How Has the United Sates Borrowed Without Cost, by Craig K. Elwell
The major implication of the dark matter argument for the dollar is that because
the true state of the U.S. trade position is not precarious and because the United states
is not a net external debtor, there is no need for a dollar depreciation to keep the debt
to GNP ratio within bounds. Foreign investors could be quite willing to hold more
dollar assets despite their having little apparent yield advantage over foreign assets.
The risk of a dollar crisis in this circumstance would be small.
Although there is probably some merit to the dark matter argument, most
economists would argue that the scale of the effect is vastly smaller than claimed by
its proponents. For that reason, economic dark matter probably does little to forestall
the need for a substantial correction of the U.S. trade deficit. And that correction
must be set in motion by a substantial real depreciation of the dollar, beyond the
depreciation that has already occurred, and that will persist for several years.
The Macroeconomic Effects of a Dollar Crisis
In the standard macroeconomic model, a reduction of foreign capital inflows
would have no long-term effect on aggregate spending and output. A real
depreciation of the dollar would encourage U.S. export sales and discourage domestic
spending on imports, increasing net exports and shrinking the trade deficit. At the
same time foreigner’s reduced willingness to hold dollar assets will reduce the
inflow of foreign capital, pushing down the price of U.S. securities, and pushing up
U.S. interest rates. Higher interest rates would then induce a decrease in interest
sensitive spending such as residential investment, consumer durables, and business
investment. In the end, the trade deficit would be gone, the composition of U.S.
spending and output would change, but there would not be any change in the total
level of spending and output.
The transition to this new equilibrium of trade balances, however, may not be
smooth. Some argue that there could be a very rough transition involving a sharp
slowdown in economic activity or a recession. Substantial near-term slowing of
economic activity would occur if the decrease of U.S. domestic spending occurs more
quickly then the increase of U.S. net-exports. Interest sensitive purchases tend to be
more postponable then other domestic spending and would likely fall relatively
quickly as interest rates spiked. Net exports’ response could be significantly slower.
The peak effect on net exports in response to a currency depreciation is usually about
two years later. However, in this situation the scale of adjustment needed to eliminate
the trade deficit is unusually large and will involve large shifts of resources into the
production of tradable goods which take time. This could slow the response of net
What aggravates this situation and significantly adds to the risk of a dollar crisis
triggering a recession is the U.S. economy’s ongoing burden of adjusting to the
housing price crisis. Falling home prices reduce household wealth, discouraging
household spending, and dampen aggregate spending. As with most markets, there
is a self correcting mechanism that facilitates beneficial adjustment in the housing
market. This occurs as weaker aggregate demand also weakens the demand for credit
and causes interest rates to decrease. By stimulating interest sensitive spending,
falling interest rates, other things equal, arrest some of the downward impulse on
aggregate demand of falling housing prices.
However, if the economy must also endure the disruptive effects of a
plummeting dollar, other things would not be equal. In a dollar crisis, great numbers
of foreign investors are attempting to sell large amounts of dollar assets at the same
time causing dollar asset prices to fall sharply and interest rates to rise sharply.
Interest rates will continue to rise until a sufficient number of dollar-averse investors
can be enticed to offer enough capital to finance the slowly shrinking current account
deficit. An interest rate spike like this is likely to forestall any ameliorating effect of
otherwise falling interest rates on the housing crisis, slowing aggregate demand more
than would otherwise occur.
In this environment, where two crises exert downward pressure on aggregate
spending, the risk rises that the short-term adjustment of the U.S. trade balance could
involve a much quicker and much larger slowing of domestic spending with so little
near-term boost from rising net exports. This magnified near-term negative impact
could be sufficient to cause a recession.
The Response of Economic Policy
The ability of conventional fiscal and monetary policy, here and abroad, to
counter the near-term contractionary effects of a dollar crisis is problematic.
Response of U.S. Economic Policy
When the government budget is in deficit, it reduces domestic saving and when
in surplus it increases domestic saving. Therefore, conceptually an infusion of
government saving caused by policy actions that reduce the federal budget deficit
could compensate for the dwindling flow of foreign savings stemming from foreign
investors move out of dollar assets. Governments adding to the domestic flow of
saving would tend to decrease interest rates and stimulate aggregate spending. This
would also mean that the trade balance adjustment could occur with out a reduction
of domestic investment. An outcome, that bodes better for productivity and the long-
term growth of the U.S. living standard.
However, to get to this point there would first be an initial dampening effect
flowing from the government’s budget deficit reducing actions of spending less,
taxing more, or doing both. In the short run, a negative fiscal impulse in conjunction
with the already occurring short-run negative effects of the housing crisis and dollar
crisis would amplify the recession risk. Also, the impulse toward lower interest rates
would mute the self-correcting effect of a rising interest differential between dollar
assets and foreign assets that would otherwise help to slow the dollar’s fall.
Again, conceptually the short-term negative effects of fiscal tightening on
aggregate spending could be countered by a complementary short-term monetary
stimulus which spurs spending through exerting downward pressure on interest rates.
In practice, however, whether alone or in tandem with monetary policy, the use of
budget deficit reduction as a policy response to the near-term problems of a dollar
crisis is improbable. The necessary tax and spending changes are unlikely to be
implemented quickly enough. Over a longer time horizon, where fiscal action may
be more likely, increased government saving from budget deficit reduction would
prevent the dwindling inflows of foreign saving from causing an undesired
compression of U.S. domestic investment.
With fiscal policy most likely out of consideration in the near-term, the task of
attempting to counter the short-term contractionary effects of a dollar crisis would
fall upon the Federal Reserve. It would most likely do this by pumping liquidity into
the economy and exerting downward pressure on interest rates. Monetary policy can
be implemented quickly and its favorable effect felt with a modest time lag.
Nevertheless, there are some potential constraints on the Fed’s ability to follow a
stimulative monetary policy during a dollar crisis.
One potential constraint is a consequence of the dollar depreciation inducing a
increase in U.S. inflation by causing the price of U.S. imports’ to rise sharply. This
inflation effect will be muted by import’s relatively small share of final demand. Also
many foreign producers will, to preserve market share, prevent a full pass-through
of the exchange rate change to the price of their products exported to the United
States. Nevertheless it is still possible that the scale of dollar depreciation in a crisis
could lead to a 1 to 2 percentage point jump in the inflation rate. This inflation effect
would stop once the dollar stabilized. But to prevent this inflation spurt from
generating an increase in inflation expectations and causing a more enduring run-up
of inflation, the Fed might be reluctant to validate those expectations by continuing
to provide monetary stimulus.
Another possible constraint on fully pursuing policy of monetary stimulus is
that if the fall of the dollar is seen by the Fed to be too extreme, policy action may be
needed to gain some control over the falling currency. Most likely this would involve
changing direction and increasing interest rates to entice foreign investors back to
Even if the Fed does not relent in applying monetary stimulus, the traditional
channel for doing this is by targeting short-term interest rates, usually the nominal
federal funds rate. However, that rate can only be decreased to zero. With the
nominal federal funds rate already down to about 2.0%, there is a question of whether
sufficient monetary stimulus could be applied before this rate reaches the so-called
At this point, there are nontraditional ways that might be used to implement
monetary policy. These include targeting longer-termed federal securities, making
direct loans to banks, or altering inflation expectations (i.e., lowering real rates via
a credible commitment to higher future inflation) that could be used. It is still
uncertain, however, if these untried alternative monetary policy levers are effective
and, if effective, whether that effect can be delivered to the economy quickly enough
to counter the sharp short-term negative impulse to domestic spending of a fast
Response of Foreign Economic Policy
The economic policy response of other economies, particularly those with trade
surpluses, could help or hinder the macroeconomic adjustment forced by a dollar
crisis. As discussed earlier, a falling dollar (and rising foreign currencies) is the
instrument that will lead to a rebalancing of world spending. For economies with
trade surpluses the rebalancing would manifest as a increase of domestic spending
and decrease of net exports.
As was true for the United States, after the rebalancing has been completed,
affected foreign economies total spending and level of output would be unchanged.
The negative effects from the decrease in net-exports caused by their currencies
appreciation will be counter-balanced by the positive effect from lower interest rates,
pushed down by increased capital inflows, boosting domestic spending. Like the
United States, however, the rest of the world’s near-term transition to this new
equilibrium might not be smooth, and also carry an elevated risk of recession.
Many U.S. trading partners have relied on export sales to the American market
as their principal, or at least their major, engine of economic growth. This practice
is most overt in those economies that tie their currency to the dollar so that dollar
depreciation does not reduce the price competitiveness of their exports. In a dollar
crisis, there could be a temptation to try to continue to prevent their currencies from
appreciating against the dollar. Defending their currencies would slow the global
adjustment. But it is unlikely to be successful policy, however, in the face of a global
attempt to move out of dollar assets and a plummeting dollar. The likely aftermath
of such an attempt would be that these economies would be left holding an even
larger stock of dollar assets whose value is a fraction of what it was when purchased.
The deflationary impact of a rising currency would help economies, such as
China, that are facing an inflation problem. On the other hand, it could cause
problems for a country like Japan that still teeters on the edge of deflation.
In general, a more useful policy response by foreign economies would likely be
expansionary economic policies sufficient to boost domestic spending and offset the
near-term negative impact of an appreciating currency on their net exports. Because
this stimulus must be applied quickly for it to be effective, the task would most likely
be undertaken by the monetary authorities.
As was true for the United States, it is problematic whether the application of
a stimulative monetary policy by the central banks of the surplus economies would
have sufficient positive effect on aggregate spending in the near-term to avoid a
strong downward push on global economic activity. In economies that are already
facing a significant inflation problem, such as China, there could be a reluctance to
fan the inflationary flames any further by undertaking added monetary expansion.
In any event, a cooperative policy response by the United States and its major trading
partners would certainly help to smooth the global adjustment to a dollar crisis.
Predicting the path of exchange rates is always an endeavor with an above
normal level of uncertainty. Nevertheless, it seems undeniable that a further sizable
depreciation of the dollar is necessary in the long run to keep the United States’ large
and growing external debt within realistic bounds. It is difficult, however, to predict
how global investors who hold the U.S. external debt will respond to the seemingly
large erosion of the value of those dollar assets caused by this inevitable depreciation
of the dollar.
A rational response to holding a currency unable to perform its role as a store
of value would be to move quickly into assets denominated in other more stable
currencies. Yet, despite the sizable depreciation of the dollar that has already
occurred, foreign investors continue to hold dollar assets. There are reasons, in
addition to the store of value function, to hold those assets. Safety and liquidity are
two other important reasons, both functions that the wide and deep dollar asset
markets perform very well. Also, many investors pursue very long term goals and
could be willing to ignore short run risk. It seems unlikely, however, that these other
reasons for holding dollar assets, would continue to trump the dollar’s rapidly
dwindling ability to provide the store of value function. If so, then a sharp dollar fall
could be just ahead.
A plummeting dollar would have positive and negative effects on the world
economy as well. Eventually the positive and negative impacts on the level of
economic activity should be offsetting, but it would leave the world economy with
more stable external balances. But, there is reason to be concerned that in the short-
run the negative effects may be dominant, raising the risk of recession.
The triggering of a recession by a plummeting dollar will depend on what else
is going on in the economy when the currency crashes. If already weakened by other
forces, the risk of recession would grow much larger. If generally good economic
conditions prevail, then economic activity is likely to slow in the near-term but avoid
It is important to take into consideration that the U.S. economy is large and
resilient, and able to absorb substantial shocks without necessarily transmitting a
significant adverse effect on overall economic activity. In contrast, a dollar crisis
could send a more devastating economic blow to economies that are highly
dependent on exporting to the U.S. market to sustain their economic growth.