The exceptional advantage the United States has in being able to issue its liabilities in its own currency has shielded it from the worst ravages of the financial crisis any other country would have experienced in its position. But fears that the United States might be forsaking this advantage are mounting. The issue isn't the imminent collapse of the dollar, but that the United States will be increasingly constrained in its fight against the economic downturn by concern over the sagging value of the dollar.
In his visit to Beijing this past summer, Treasury Secretary Timothy Geithner looked like a wastrel trying to appease his creditors, giving assurances to skeptical Chinese audiences. Increasingly, the Fed finds it has to assure investors of its "exit strategy" from extreme monetary easing. Yet, the only thing that can sustain aggregate demand, and thus income and employment, in the period to come is to keep up the fiscal stimulus. Anything that poses a threat to the large budget deficits the Obama Administration is running—and will continue to in the coming years—is liable to worsen the economic slump. Whether warranted, inflation fears pose a threat.
Two valid points are often made by those who argue that inflation fears are not warranted in the current period. First, substantial slack in both the labor market and in industrial capacity militate against any wage increases or pricing power on the part of businesses—which is definitely true. Second, the liquidity the Fed has been injecting into banks cannot cause inflation unless it first leads to a lending spree. This is again not something to worry about, given the continuing anemic state of bank credit today. Banks have had to shrink their balance sheets drastically and the public sector had to expand its own to check the free fall in asset prices. If the Fed can rapidly reduce its own balance sheet when banks begin expanding their balance sheets again, the argument goes, inflation will not or need not be a problem. While both points are valid it does not follow that inflation is not a concern. The fear of inflation itself poses a threat for the creditworthiness of the United States as an international net borrower.
It is a bad omen that with the slightest sign of improvement in the world economy demand for the dollar began to sag. The rise of oil and commodities in the last few years as an asset class to invest in is emblematic of the ebbing confidence in the dollar, of the fact that U.S. financial liabilities can no longer mop up the excess liquidity the United States is creating in the world economy. If the economy continues to show signs of improvement, the recent upward trend in oil and commodity prices will only gain momentum, causing inflation fears to intensify. We glimpsed the vicious cycle this can give rise to last summer when investors' efforts to hedge against the dollar caused a speculative bubble in oil and commodity prices, raising inflationary expectations, which further undermined the dollar. The same is likely to happen again.
A safer way to inflate the U.S. economy would have been to couple that policy with international currency reform. Much has been written on this issue here and elsewhere. But there is no sign of any inclination on the part of the Obama Administration to move in that direction, and, clearly, the Chinese and Russian rumblings about the dollar have had little effect on making global monetary reform imminent. The trouble is that output and employment will have to stay depressed to keep U.S. inflation fears from threatening to turn the slide of the dollar, so far orderly, into a rout. Economic malaise will keep concerns about both in check and may be the best we can hope for.
The irony is that U.S. financial markets and neoliberal global order were perversely functional in recycling other countries' trade surpluses to the United States and through it to the rest of the world. The problem was how they were recycled. Consumption booms on borrowed money caused insolvency in the emerging economies. The same thing happened in the United States when recycled global surpluses became fodder for excessive credit growth here as well, bankrupting its households and banks. Now, the difficulty in recycling these imbalances is causing them to shrink, and that is in a nutshell the driving force behind the global slump. Oddly, current U.S. policy amounts to fighting the slump by trying to return to business as usual even though it is recognized that U.S. private consumption can no longer be the engine of growth and rising fiscal deficits pose a problem.
Exports will have to rise to counter the downward slide, for they are the only way to bolster aggregate demand without adding on debt. That in turn requires more than a weak dollar. The level of income has to rise in the rest of the world, and that is why many commentators have recently been calling for surplus countries to hike up spending in their respective economies and be the new engine of world growth. But, even if surplus countries recognize that that is in their enlightened self-interest, they face a classic collective action problem. Whichever country fails to reflate its economy can gain by bolstering its exports at the expense of those who do. In the absence of some global coordination mechanism it is unrealistic to expect surplus countries to overcome their fear of losing their competitiveness through reflation. Secondly, the onus of adjustment is never on them. Unsurprisingly, U.S. efforts to push reflation in surplus countries onto the agenda in the recent G20 Summit did not go anywhere as both Germany and China were cool to the idea.
If collective action problems or even mere shortsightedness prevent surplus countries from acting on their enlightened self interest, where does that leave us? An alternative approach could be to aim at recycling global surpluses to fund development in developing countries. Provided there is sufficient political will, bonds issued by poor countries can be funded by an international financial institution, which can in turn issue its own liabilities that can function as reserve assets alternative to the U.S. Treasuries, which the surplus countries can invest in. This would not only relieve the tension on the dollar but also help revive the recycling of global imbalances on sound footing. Moreover, it would also save the world the political tensions that would inevitably rise when China sooner or later stumbles on its own Marshall Plan in the developing world.
