Reply #57: America’s privilege, the world’s worry

[54anickel]

http://www.economist.com/agenda/PrinterFriendly.cfm?Story_ID=3372405


CHARLES DE GAULLE, founder of France’s fifth republic, famously resented America’s paramount position in the global economy of the 1960s. The United States, he complained, enjoyed an “exorbitant privilege”. Because its currency, the dollar, served as the world’s reserve asset, America could live beyond its means, unconstrained by the periodic shortages of foreign exchange that haunted other, less privileged nations. Nicolas Sarkozy, France’s spirited finance minister, wants to inherit de Gaulle’s mantle as president of the fifth republic. Though somewhat smaller in stature than the great general, both physically and politically, Mr Sarkozy seems to share his outsized resentment of America’s economic privileges.

Mr Sarkozy has more to envy than de Gaulle ever had. Today’s America lives beyond its means more flagrantly than ever before. Its government will spend about $427 billion more than it raises in taxes this year. The nation as a whole is running a deficit of $571.9 billion on its current account with the rest of the world. These twin deficits, Mr Sarkozy points out, weigh heavily on the dollar. The currency’s fall, interrupted in February, has resumed. On Monday November 8th, it plumbed a new low against the euro of close to $1.30. Only if America restrains its deficits will the markets regain confidence in the dollar, Mr Sarkozy warned. “This is a unanimous message from the Europeans and the International Monetary Fund that we send to the United States.” On Wednesday, the dollar dipped again, this time breaching the $1.30-per-euro mark.

Mr Sarkozy no doubt fears that his American counterparts are quite happy to watch the dollar fall. Their professed commitment to a “strong dollar policy” might disguise a policy of benign neglect. America’s net overseas liabilities amounted to 23% of GDP at the end of last year, close to the record debts it amassed in 1894, according to Ken Rogoff and Maurice Obstfeld of the National Bureau of Economic Research. Crucially, the bulk of these debts are denominated in dollars. Thus America may be sorely tempted to dishonour its dollar debts, not by defaulting on them, but by devaluing them.

The immediate casualties of such a policy would be America’s East Asian creditors. By the end of last year, Asian central banks held $1.89 trillion of foreign reserves, the vast bulk of them in dollars. If these reserves lost value, Asian economies would suffer an almighty capital loss in domestic-currency terms. A recent study by the New York Federal Reserve counted the costs. If the Chinese yuan were to appreciate by 10% against the dollar (and other reserve currencies), China would suffer a capital loss worth almost 3% of GDP, the study found. If the won rose by 10%, South Korea would suffer similarly. The toll would be even greater in Singapore (10% of GDP) and Taiwan (8%).

To avert such an appreciation, Asian central banks would have to amass ever greater holdings of dollars. But this would only expose them to greater capital losses down the road. Alternatively, they might seek to avoid the consequences of a dollar fall, by diversifying into other reserve currencies, such as the euro. But that would only bring the dollar crashing down all the more quickly. In other words, Asian central banks are caught in an awkward dilemma: either they try to break the dollar’s fall, or they try to escape from underneath its collapse.

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