The U.S. government has pulled out all the stops to try to get the economy back on track after the Great Recession: It is running a huge budget deficit, the financial sector has been bailed out, and the Federal Reserve is keeping interest rates ultra-low.
But the efforts to get the economy going again create risks of their own. One of the biggest is that the value of the dollar could decline in ways that are abrupt and disruptive.
The dollar has already been drifting gradually downward as a result of large U.S. trade and budget deficits and the growing economic might of the rest of the world. It is down 36 percent against six other major currencies over the past decade — and was down even more before the 2008 financial crisis prompted fearful investors to plow money into dollars.
The downward trend is likely to continue as the other economies continue to catch up with the United States. The risk now is that large U.S. budget deficits, a lack of political consensus over how to reduce them and the Fed’s low-interest-rate policies will transform the slow decline into a precipitous fall.
“There is an ongoing, very gradual diversification away from the dollar,” Barry Eichengreen, an economist at the University of California at Berkeley and author of “Exorbitant Privilege,” said about the unique role of the dollar in the world economy. “That movement could be very significantly hastened if foreigners grow concerned about deficits as far as the eye can see and the pressure the Fed will feel not to normalize the level of interest rates, resulting in inflation.”
At the moment, the dollar and U.S. Treasury securities are trading at prices that reflect investor confidence in the future of the greenback. The dollar is still the preferred currency for a vast array of transactions, even many that take place outside of the United States and don’t involve Americans. Nations around the world put their rainy-day savings, known as reserves, into dollars, and investors pour money into U.S. Treasury bonds whenever the economic outlook becomes unnerving.
But that arrangement might not last.
The euro has already emerged as a competitor. The currency is in use across 17 European economies that together are roughly equal to that of the United States. Despite recent financial crises in several of those countries, the euro has rallied 15 percent against the dollar since mid-January, in part because the European Central Bank has been more willing to raise interest rates than the Fed.
China’s currency could emerge as a global rival to the dollar if Chinese officials accelerate their recent moves to ease control over how the renminbi is used and allow its value to better reflect market forces. The prospects for the Japanese yen look less promising, especially because Japan’s debt is even larger than that of the United States relative to the size of its economy.
“You can view the dollar in isolation and work yourself up into a lather that this is really a dismal outlook, with the intractable U.S. budget problems and a sense that in the long run the only way out will be inflation,” said Desmond Lachman, a resident fellow at the American Enterprise Institute. “But you have to look at what’s happening in Europe and what’s happening in Japan, and ask yourself against what is the dollar really going to be depreciating.”
History is full of examples of countries where large budget deficits eventually led investors to lose faith, causing the currency to tumble. The Asian financial crisis, which rocked the likes of Thailand, Singapore and South Korea in the late 1990s, is one recent example.
If global investors suddenly lost confidence in the value of the dollar, they would demand higher interest rates to lend money to the U.S. government. That could make it more expensive for the government to continue financing its debts, aggravating the budget crisis further.
Carmen Reinhart, a senior fellow at the Peterson Institute for International Economics who studies financial crises, said a rapid decline in the dollar is not likely. But she noted that the meltdown of global financial markets in 2008 would also have seemed unlikely two years earlier.
“The improbable does happen,” she said.
Reinhart warned that treating the prospect of a dollar collapse as unlikely could actually help it happen. If elected officials don’t develop a plan for bringing down budget deficits over time, for example, it could make a rapid loss of confidence in the dollar more likely.
Ask the British. Just a century ago, the pound was the dominant currency used for global trade and London the financial capital of the world. But over just a decade, from 1914 to 1924, the dollar supplanted the pound as the leading global currency as the British took on massive debts to pay for waging World War I, and the United States created the Federal Reserve and with it a more stable banking system.
Eichengreen has studied this pivotal decade and highlights its lessons for today.
“There’s not going to be a massive flight away from the dollar all at once, because there’s nowhere to flee to,” he said. “But this ongoing process of moving away from the dollar will be accelerated by doubts about whether U.S. policy is being conducted in a responsible way.”