The Overstretch Myth

David H. Levey and Stuart S. Brown

From Foreign Affairs, December 2005 -- WTO Special Edition

Summary:  The United States' current account deficit and foreign debt are not dire threats to its global position, as would-be Cassandras warn. U.S. power is firmly grounded on economic superiority and financial stability that will not end soon.

David H. Levey recently retired after 19 years as Managing Director of Moody's Sovereign Ratings Service. Stuart S. Brown is Professor of Economics and International Relations in the Moynihan Institute of Global Affairs at Syracuse University's Maxwell School of Citizenship and Public Affairs.

Official Asian capital inflows, moreover, should soon be supplemented by a renewal of private inflows responding to the next stage of the information technology (IT) revolution. Technological revolutions unfold in stages over many decades. The IT revolution had its roots in World War II and has proceeded via the development of the mainframe computer, the integrated circuit, the microprocessor, and the personal computer to culminate in the union of computers and telecommunications that has brought the Internet. The United States--thanks to its openness, its low regulatory burden, its flexible labor and capital markets, a positive environment for new business formation, and a financial market that supports new technology--has dominated every phase of this technological wave. The spread of the IT revolution to additional sectors and new industries thus makes a revival of U.S.-bound private capital flows likely.

A SOFTER LANDING

Whichever perspective on the current account one favors, the United States cannot escape a growing external debt. The "hegemony skeptics" fear such debt will lead to a collapse of the U.S. dollar triggered by a precipitous unloading of U.S. assets. Such a selloff could result--as in emerging-market crises--if investors suddenly conclude that U.S. foreign debt has become unsustainably large. A panicky "capital flight" would ensue, as investors raced for the exits to avoid the falling dollar and plunging stock and bond prices.

But even if such a sharp break occurs--which is less likely than a gradual adjustment of exchange rates and interest rates--market-based adjustments will mitigate the consequences. Responding to a relative price decline in U.S. assets and likely Federal Reserve action to raise interest rates, U.S. investors (arguably accompanied by bargain-hunting foreign investors) would repatriate some of their $4 trillion in foreign holdings in order to buy (now undervalued) assets, tempering the price decline for domestic stocks and bonds. A significant repatriation of funds would thus slow the pace of the dollar decline and the rise in rates. The ensuing recession, combined with the cheaper dollar, would eventually combine to improve the trade balance. Although the period of global rebalancing would be painful for U.S. consumers and workers, it would be even harder on the European and Japanese economies, with their propensity for deflation and stagnation. Such a transitory adjustment would be unpleasant, but it would not undermine the economic foundations of U.S. hegemony.

The U.S. dollar will remain dominant in global trade, payments, and capital flows, based as it is in a country with safe, well-regulated financial markets. Provided U.S. firms maintain their entrepreneurial edge--and despite much anxiety, there is little reason to expect otherwise--global asset managers will continue to want to hold portfolios rich in U.S. corporate stocks and bonds. Although foreign private demand for U.S. assets will fluctuate--witness the slowdown in purchases that precipitated the decline in the U.S. dollar in 2002 and 2003--rapid growth of world financial wealth will allow the proportion of U.S. assets held by foreigners to increase.

For foreign central banks (as well as commercial financial institutions), U.S. Treasury bonds, government-supported agency bonds, and deposits in highly rated banks will remain, for the foreseeable future, the chief sources of liquid reserve assets. Many analysts have pointed to the euro as a threat to the dollar's status as the world's central reserve currency. But the continuing strength of the U.S. economy relative to the European Union's and the structure of European capital markets make such a prospect highly unlikely. On the basis of likely demographic and productivity growth differentials, Adam Posen of the Institute for International Economics estimates that the U.S. economy will be at least 20 percent larger than that of the EU in 2020. The United States will maintain its 22 percent share of world output, but Europe's share will, in the absence of serious structural reforms, shrink by 3 to 5 percent. Moreover, European government bond markets, although larger than the U.S. Treasury market, are divided among five large countries and a host of smaller ones, greatly reducing liquidity, and European corporate bond and equity markets are smaller than their U.S. counterparts. With Asian capital markets still in their infancy, it will be a very long time before the pre-eminence of the dollar and U.S. capital markets is challenged.

At the peak of its global power the United Kingdom was a net creditor, but as it entered the twentieth century, it started losing its economic dominance to Germany and the United States. In contrast, the United States is a large net debtor. But in its case, no plausible challenger to its economic leadership exists, and its share of the global economy will not decline. Focusing exclusively on the NIIP obscures the United States' institutional, technological, and demographic advantages. Such advantages are further bolstered by the underlying complementarities between the U.S. economy and the economies of the developing world--especially those in Asia. The United States continues to reap major gains from what Charles de Gaulle called its "exorbitant privilege," its unique role in providing global liquidity by running chronic external imbalances. The resulting inflow of productivity-enhancing capital has strengthened its underlying economic position. Only one development could upset this optimistic prognosis: an end to the technological dynamism, openness to trade, and flexibility that have powered the U.S. economy. The biggest threat to U.S. hegemony, accordingly, stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.