Betting With the House’s Money

Kenneth Rogoff
Kenneth Rogoff
Kenneth Rogoff Thomas D. Cabot Professor of Public Policy and Professor of Economics - Harvard University, Former Brookings Expert

February 15, 2007

Many people have been asking why the dollar hasn’t crashed yet. Will the United States ever face a bill for the string of massive trade deficits that it has been running for more than a decade? Including interest payments on past deficits, the tab for 2006 alone was over $800 billion dollars – roughly 6.5% of US gross national product. Even more staggeringly, US borrowing now soaks up more than two-thirds of the combined excess savings of all the surplus countries in the world, including China, Japan, Germany, and the OPEC states.

Foreigners are hardly reaping great returns on investing in the US. On the contrary, they typically get significantly lower returns than Americans get on their investments abroad. In an era in which stock and housing prices are soaring, the central banks of Japan and China are holding almost two trillion dollars worth of low-interest bonds. A very large share of these are US treasury bonds and mortgages. This enormous subsidy to American taxpayers is, in many ways, the world’s largest foreign aid program.

If America’s competitive position is so weak, what magic is holding up the dollar? Most sober analysts have long been projecting a steady trend decline in the dollar against the currencies of America’s trading partners, especially in Asia and emerging markets. So why hasn’t more adjustment taken place already?

The first answer, of course, is that the trade-weighted dollar has fallen – by more than 15% in real terms since its peak in early 2002. Yet the US deficits have persisted, and even risen, since then.

The real driving force has been two-fold. First and foremost, America’s government and consumers have been engaged in a never-ending consumption binge. On the consumer side, this is quite understandable. With over 80% home ownership, the epic boom in housing prices of the last ten years has spread deep into the American middle class. Equity holdings are somewhat more concentrated, but many middle class Americans have still benefited indirectly through their pension funds.

Overall, after almost 25 years of stunning prosperity, punctuated by only two mild recessions, most Americans feel pretty confident about their economic situation. Unemployment is at a cyclical low, and the economy appears to be less volatile than at any point in modern history. So it is not surprising that private consumption continues to hold up even as US economic growth has shifted into lower gear. People have enjoyed such huge capital gains over the past decade that most feel like gamblers on a long winning streak. By now, they see themselves as playing with the house’s (or their houses’) money.

It is less easy to rationalize why the US government is continuing to run budget deficits despite a cyclical boom. When a fiscally responsible government launches a war, it typically cuts back on other domestic expenditures and raises taxes. The Bush administration did the opposite. It may not be good economics, but the strategy proved to be good politics, for a time. Unfortunately, it is unlikely the new Democratic majority in Congress will do much about it.

Of course, it takes two to tango. In order for the US economy to run deficits with the world, other countries must be willing to spin off a counterbalancing supply of savings. Ben Bernanke, the US Federal Reserve chairman, once famously pinned the whole US current account deficit on a “global savings glut.” But it would be more accurate to say that there is global investment shortfall, with investment trending downwards despite the upward trend in global growth.

This investment shortfall is due to many factors, but perhaps the main one is that there are substantial medium-term institutional roadblocks to investment in many developing countries, where long-term returns now seem to be by far the highest. The net result is that money is being parked temporarily in low-yield investments in the US, although this cannot be the long-run trend.

What then is future of the dollar?

As long as the status quo persists, with strong global growth and stunning macroeconomic stability, the US can continue to borrow and run trade deficits without immediate consequence. Over time, the dollar will still decline, but perhaps by no more than a couple of percent per year. Nevertheless, it is not hard to imagine scenarios in which the dollar collapses. Nuclear terrorism, a slowdown in China, or a sharp escalation of violence in the Middle East could all blow the lid off the current economic dynamic.

In principle, one can also think of scenarios in which the dollar shoots up, but overall these seem less likely. In sum, the fact that the US trade balance has defied gravity for so many years has made it possible for the dollar to do so, too. But some day, the US may well have to pay the bill for its spendthrift ways. When that day arrives, Americans had better pray that their creditors will be as happy to accept dollars as they are now.

View the original article on the Project Syndicate web site.