The Dollar and the Deficits

How Washington Can Prevent the Next Crisis

A tourist gazes up towards the dome of the U.S. Capitol in Washington January 25, 2010. Kevin Lamarque / Reuters

Even as efforts to recover from the current crisis go forward, the United States should launch new policies to avoid large external deficits, balance the budget, and adapt to a global currency system less centered on the dollar. Although it will take a number of years to fully implement these measures, they should be initiated promptly both to bolster confidence in the recovery and to build the foundation for a sustainable U.S. economy over the long haul. This is not just an economic imperative but a foreign policy and national security one as well.

A first step is to recognize the dangers of standing pat. For example, the United States' trade and current account deficits have declined sharply over the last three years, but absent new policy action, they are likely to start climbing again, rising to record levels and far beyond. Or take the dollar. Its role as the dominant international currency has made it much easier for the United States to finance, and thus run up, large trade and current account deficits with the rest of the world over the past 30 years. These huge inflows of foreign capital, however, turned out to be an important cause of the current economic crisis, because they contributed to the low interest rates, excessive liquidity, and loose monetary policies that -- in combination with lax financial supervision -- brought on the overleveraging and underpricing of risk that produced the meltdown.

It has long been known that large external deficits pose substantial risks to the U.S. economy because foreign investors might at some point refuse to finance these deficits on terms compatible with U.S. prosperity. Any sudden stop in lending to the United States would drive the dollar down, push inflation and interest rates up, and perhaps bring on a hard landing for the United States -- and the world economy at large. But it is now evident that it can be equally or even more damaging if foreign investors do

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