Riding for a Fall

Peter G. Peterson

From Foreign Affairs, September/October 2004

Summary:  Three long-term trends are threatening to bankrupt America: the burgeoning costs of waging the war on terrorism, the U.S. economy's increasing reliance on foreign capital, and rapid aging throughout the developed world. Washington must understand that committing the United States to a broader global role while ignoring the financial costs of doing so is deeply irresponsible.

Peter G. Peterson is Chairman of the Council on Foreign Relations, the Institute for International Economics, and The Blackstone Group. He served as Secretary of Commerce in the Nixon administration. This article is adapted from "Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It," published by Farrar, Straus, and Giroux, LLC. Copyright (c) 2004 by Peter G. Peterson. All rights reserved

Dreary as this scenario is, this sort of "soft landing" is the very best outcome we could expect so long as the United States' future fiscal path and national savings rate remain unchanged. But according to many economists, it is quite possible that the dynamic of gradual adjustment will at some point be trumped by a sudden loss of confidence, leading to a run on the dollar. If the dollar were to overshoot in a large and sudden plunge, inflation and interest rates could well jump substantially and financial markets could ratchet downward. The United States has already experienced some sort of dollar run four times over the last 30 years--in 1971-73, 1978-79, 1985-87, and 1994-95--with far less daunting projections than those of today. They typically began after the dollar had already been declining gently for some time. None was as serious as the hard landing the United States may yet face.

The next dollar run, should it happen, would likely lead to serious reverberations in the "real" economy, including a loss of consumer and investor confidence, a severe contraction, and ultimately a global recession. Soaring interest rates would cause the federal deficit to jump, as U.S. Treasury bond buyers demanded much higher returns. If short-term Treasury rates were to jump back to the four to five percent range, federal interest outlays would climb by $30 billion in the first year and by as much as $50 billion in the second year. Rather than improve the prospect of fiscal reform, gloomy economic conditions could delay it further.

Virtually none of the policy leaders, financial traders, and economists interviewed by this author believes the U.S. current account deficit is sustainable at current levels for much longer than five more years. Many see a real risk of a crisis. Former Federal Reserve Chairman Paul Volcker says the odds of this happening are around 75 percent within the next five years; former Treasury Secretary Robert Rubin talks of "a day of serious reckoning." What might trigger such a crisis? Almost anything: an act of terrorism, a bad day on Wall Street, a disappointing employment report, or even a testy remark by a central banker.

Skeptics say not to worry because governments around the world would never allow a crisis to happen. They would intervene massively to support the American currency by buying dollars. Indeed, they might try. But foreign governments might lose their nerve sooner than place vast sums of their own taxpayers' money into declining dollar-denominated assets. And once the mood of private investors worldwide changed decisively, there would be little that governments could do, even if they had nerves of steel. The magnitude of tradable assets around the world (global stock markets alone are now capitalized at over $30 trillion) would overwhelm the efforts of even the most dedicated band of central bankers or treasurers.

The skeptics are right about one thing: most governments have no great desire to correct the current imbalance of global trade and finance. Foreign leaders are as eager to stimulate their economies with a bustling export sector as U.S. political leaders are to keep running budget deficits at low interest rates. Fred Bergsten, director of the Institute for International Economics, observes, "We finally understand the true meaning of supply-side economics. Foreigners supply most of the goods and all of the money." It is an ugly but politically convenient arrangement. But it cannot be sustained indefinitely.

Most economists assume some sort of readjustment is inevitable. For the United States to export more and import less, however, it follows by arithmetic that the rest of the world must do the reverse. What if the rest of the world refuses? In a deflationary era of slack demand, some world leaders may feel compelled to maintain their trade surpluses by whatever means available: buying dollars, cutting interest rates, subsidizing exports, or resorting to outright protectionism and capital controls. Such policies may succeed for a time in delaying the readjustment, but only at the cost of throwing the global economy further out of kilter and worsening Rubin's "day of serious reckoning" when it arrives.

The question is not just hypothetical. With the substantial fall in the exchange value of the dollar since the beginning of 2002, global investors may be telling markets that a partial readjustment of the U.S. current account deficit is overdue. Although this fall has largely been accepted by some countries--members of the eurozone and Canada, for example--it has been largely rejected by others, most notably Japan, Taiwan, South Korea, and China (the currency of which is pegged to the dollar). The resulting regional asymmetry means that those who follow the "euro path" get hammered, whereas those who follow the "Asian path" get off easier by resisting the readjustment. In time, without better global cooperation, those following the euro path may give up and resort to a variety of surplus-preservation measures, such as subtle import restrictions and other de facto protectionist moves.

Although no one can predict how the current imbalance in the global economy will play out, trade economists marvel at just how many ways this lopsided flywheel can spin off the axle. One thing that economists agree on is that for the world to readjust to a path of balanced growth, the United States must export more and save more while the rest of the world must import more and consume more. This will require major shifts of labor and capital, not to mention profound cultural changes within all these economies.

Yet if moving to equilibrium too fast (the plunging dollar scenario) is full of peril, so is moving there too slowly by keeping adjustments on hold. And so too, for that matter, would be the situation in which different regions work at cross-purposes. All of these risks will have to be borne, moreover, during an era in which a major act of terrorism or war could send shock waves through global financial markets at any moment. Of course, the United States will try to exercise its global leadership and get every region to cooperate. But what happens to the dollar and the global economy depends as much on what foreign political leaders and investors do as on any unilateral U.S. policy.

That is so because America's economic leverage is diminished. A quarter of a century ago, the United States was still the largest net lender on earth; 20 years ago, its global assets still exceeded its liabilities. Today, however, its net investment position is sinking below negative $3 trillion. Americans may hope that the rest of the world will go on lending unlimited funds forever. That wish, however, is unrealistic.