U.S. Futures and Out-of-Control Deficits

Given low interest rates and the still-weak U.S. economy, it will be tempting for the U.S. government to continue running deficits and issuing additional debt. At some point, however, investors will recognize this behavior for the Ponzi scheme it is. They will then come to understand that the real alternatives to the conundrum facing the United States ultimately reduce themselves to measures to drive down the real value of the debt, presumably by inflating it away.

Since investors look forward, they will want to close out their dollar positions as soon as they recognize this path as inevitable — and hence long before this inflation actually happens.

U.S. interest rates could rise by a full percentage point, if foreign investors refuse to accumulate additional dollar securities as they flow onto the market. More alarmingly, foreign investors could become unwilling to hold dollar securities, period. Selling their holdings will have even larger interest-rate and exchange-rate effects than simply refusing to absorb additional issues.

Anticipating continued dollar depreciation, residents of other countries will see no reason to risk pricing their exports in dollars. They will not accept payment in that form, just as Britain’s creditors refused to accept sterling in 1956.

If history is any guide, this scenario will develop not gradually but abruptly. Previously gullible investors will wake up one morning and conclude that the situation is beyond salvation. They will scramble to get out. Interest rates in the United States will shoot up. The dollar will fall.

The United States will suffer the kind of crisis that Europe experienced in 2010, but magnified. These events will not happen tomorrow. But Europe’s experience reminds us that we probably have less time than commonly supposed to take the steps needed to avert them.

Doing so will require a combination of tax increases and expenditure cuts. At 19% of GDP, federal revenues are far below those raised by central governments in other advanced economies. With spending on items other than health care, Social Security, defense and interest on the debt having shrunk from 14% of GDP in the 1970s to 10% today, there is essentially no non-defense discretionary spending left to cut. One can imagine finding small savings within that 10%, but not cutting it by half or more in order to close the fiscal gap.

It is wishful thinking to believe that there exists that much waste, fraud and abuse to eliminate. And after 2015, as the baby boomers retire, current budget plans imply federal government spending on the order of 25% of GDP. Under current law, federal spending will rise to 40% of GDP over the subsequent quarter century, which is just a way of saying that current law cannot remain unchanged.

A new era of peace and reconciliation may descend on the world, allowing for additional reductions in defense spending. Or there may be agreement on further health-care reform that significantly bends the cost curve for service delivery. It is not clear which scenario is more fanciful.

It is hard to avoid the conclusion that restoring fiscal balance will require dealing with entitlements. It will require agreement to limit pension costs by raising the retirement age. The problem of funding Social Security can be alleviated by liberalizing immigration policy.

There will also have to be agreement on what U.S. politicians euphemistically refer to as “revenue enhancement.” One can imagine imposing higher gasoline taxes at the pump or auctioning off greenhouse gas permits. One can imagine the imposition of a value-added tax.

But with a Republican Party unconditionally opposed to all new taxes, a Democratic president who campaigned on a promise not to raise the taxes of the middle class, and a well-organized American Association of Retired Persons to lobby against Social Security and Medicare cuts, it is uncertain whether any of these sensible outcomes can be produced by normal congressional politics, as the failure of the so-called Super Committee just underscored.

In the end, there is no substitute for achieving political consensus in the U.S. Congress and nationally on how to solve the fiscal problem.

Procedural changes can help. But meaningful reform will require political consensus on the ends to which procedural changes are the means. A dollar crisis could be the event that precipitates the necessary reforms. Better, of course, would be the mere possibility of a dollar crisis.

This said, the United States is not the only economy with fiscal challenges. The euro area, having received an early wake-up call, is now making efforts to put its fiscal house in order, but it will be years before we learn whether it succeeds. Japan, confident that it is safe because its debt is held almost entirely by its own residents, has barely begun doing likewise. The task for both is complicated by slowly growing labor forces and rapidly aging populations.

The dollar’s prospects may be bleak, but, as always when thinking about exchange rates, it is necessary to ask: Bleaker than what? People have been wrong before when betting against the U.S. economy. They have been wrong before when betting against the dollar. They could be wrong again.

Or they could be right, in which case the dollar’s exorbitant privilege will be no more.

Editor’s Note: This feature is reprinted from “EXORBITANT PRIVILEGE: The Rise and Fall of the Dollar and the Future of the International Monetary System” by Barry Eichengreen with permission from Oxford University Press, Inc. Copyright © 2011 by Barry Eichengreen.