How Scary Is the Deficit?

Now, foreign central banks with large dollar holdings are facing the prospect of huge losses as a result of the dollar's decline. A 20 percent increase in the value of the yuan against the dollar would reduce the value of China's roughly $450 billion in dollar reserves by about $100 billion -- 6 percent of China's GDP. In four years, if nothing changes, Chinese dollar reserves could reach $1.4 trillion, raising the costs of a falling dollar to $300 billion -- some 12 percent of China's GDP. In short, the longer China continues to finance U.S. deficits, the larger its ultimate losses.

More important, the current arrangement increasingly risks creating domestic financial trouble. Growing reserves naturally lead to growth in the money supply, raising the risk of inflation. In order to avert this risk, central banks must resort to a process called "sterilization": selling local-currency bonds to reduce the amount of cash in circulation. But this process is expensive, especially if local interest rates are higher than dollar interest rates. Chinese domestic interest rates are low, so China does not face this problem. But it does face another: rapid monetary growth has contributed to a boom in bank credit, excessive investment growth, and a real estate bubble. Thus far, China has used price controls to keep prices from rising, but such controls, which cause deep distortions in the economy, cannot keep the lid on inflation forever. Eventually, rising domestic prices will erode China's competitiveness even if it keeps its currency pegged at its current level. China is likely to let its currency appreciate rather than accept socially and politically destabilizing inflation.

Let's face it: most Asian central banks view financing the U.S. deficit as a burden, one that they would rather not shoulder. A recent survey of central banks (which did not include the People's Bank of China or the Bank of Japan) indicated that most want to scale back their dollar purchases, and some smaller central banks are already adding more euros and yen to their portfolios. In March, a former manager of China's currency reserves questioned China's current development strategy, asking why it should seek out foreign investors looking for a 15 percent return on their investment only to have the central bank lend these funds back to the United States at 4 percent. China will conclude that rapid accumulation of dollar reserves no longer serves its interests sooner than optimists think.

Many claim that Asian central banks have to hold on to their dollars -- and the U.S. bonds that they have bought with their dollars -- because a selloff would drive the market for dollars lower and thus be self-defeating. This argument, however, misses a key point: foreign central banks do not need to dump their existing stocks of U.S. dollars to cause financial distress in the United States; they only need to slow their new purchases of dollar debt. If central banks decide that $2.5 trillion in dollar reserves is enough, the result will be a sharp fall in the dollar and a sharp rise in U.S. interest rates.

Levey and Brown further argue that even if foreign central banks scale back their financing, there is little to worry about, since the United States is on the verge of a new information technology (IT) revolution that will attract a new wave of investment from abroad. Alas, there is little evidence to suggest this pleasant scenario will come to pass. In both 2003 and 2004, equity investors took more than $150 billion out of the United States: U.S. direct investment abroad exceeded foreign direct investment in the United States, and U.S. purchases of foreign stocks exceeded foreign purchases of U.S. stocks. High equity inflows are more likely to come because a further fall in the dollar makes U.S. assets fire-sale cheap than because of a scramble to get in on another IT boom.

Other countries do of course depend on U.S. spending to make up for a lack of demand inside their own economies. But the United States cannot take comfort in the fact that the necessary "adjustment" will be painful abroad. If a falling dollar slows German, Japanese, or even Chinese growth, it will become even harder for the United States to reduce its trade deficit by exporting more -- a key part of any "soft landing" scenario.

And even if the United States has relatively little to fear from a falling dollar, it has much to fear from an increase in interest rates. If central banks ever cut back on their dollar purchases, private investors abroad would likely demand much higher interest rates. They would have to be compensated for the risk of buying a dollar that may fall even more. Given how leveraged the U.S. economy has become, with large domestic and external debts, any large rise in interest rates would do significant damage.

POWER DRAIN

There is little doubt that U.S. external debt and the current account deficit are eroding the appeal of the U.S. approach to economic policy, an important element of U.S. "soft power." Asian policymakers, in particular, view U.S. economic policy not as a model but as a problem: the United States' "exorbitant privilege" -- Charles de Gaulle's term for Washington's ability to finance deficits by printing dollars -- comes at their expense.