LAST WEEK brought a warning to economic policymakers on both ends of Pennsylvania Avenue. A rumor that South Korea's central bank had decided to shift its reserves away from dollars triggered a sharp fall in the greenback and a retreat on Wall Street. The fact that the South Koreans later denied this rumor is only half-comforting. Economic logic is pushing Asia's central banks to quit propping up the dollar. If a hollow rumor can rattle the currency, what would a real policy change do?
The dollar's vulnerability reflects the nation's trade deficit. To sustain their appetite for foreign goods, Americans need to convert their dollars into other currencies, depressing the greenback's value. This didn't stop the dollar from being strong in the 1990s, because the trade deficit was smaller then and because foreign investors were hungry for American stocks, bonds and other assets, reflecting the U.S. economy's enviable performance. But now foreign investors' appetite for dollars lags behind Americans' demand for foreign goods and services. The gap is being filled by Asian governments, whose central banks have accumulated vast piles of U.S. bonds in an attempt to slow the dollar's slide.
A year or so ago, a fashionable theory held that this Asian government support could continue indefinitely. Asian policymakers, according to this theory, would prop up the dollar to keep their own currencies competitive. It's true that export-led growth is a quasi-religion in East Asia and that China's dictators fear their grip on power might falter if they can't keep growth and job creation humming. But China and its neighbors have proved themselves capable of fast growth even in periods when they haven't been artificially depressing their own currencies. So it seems dangerous to bet that Asian central banks will think it worth the risk of holding ever-expanding dollar portfolios that can falter on a rumor.
The other optimistic theory is that while Asians may not want to prop up the dollar, they are prisoners of their own policy. By now they've bought so many dollars that if they quit buying, the value of their existing reserves would tank. But what if one central bank worries that others will stop buying dollars first? Such fears could trigger a stampede for the exit.
None of this is to say that a dollar crash is inevitable. The dollar may fall gently, as it has over the past year or so, or a renewed appetite for U.S. assets among private investors could even stabilize its value. But the risk of a currency crash grows every day. In 2003, the United States had to attract $530 billion of foreign capital to finance its purchases of foreign stuff; in 2004 it had to attract $650 billion; this year, it may have to pull in as much as $800 billion. Every year of vast borrowing increases borrowing in later years; as Brad Setser of Oxford University notes, just paying interest on the $800 billion borrowed in 2005 might add $40 billion to the overall 2006 deficit.
To stabilize this house of cards, Congress and the administration should pull the one lever they have: They should reduce the nation's reliance on foreign capital by cutting government borrowing. This isn't going to be possible through spending cuts alone. It's going to take higher taxes.