Americans traveling overseas or buying imported goods are finding that bargains are not as plentiful as they once were. It takes approximately $1.30 to buy a euro today; five years ago a euro could be had for about 88¢. Such a decline in the dollar, along with a growing current account deficit (a current account deficit means that Americans are borrowing more from foreigners than foreigners are borrowing from Americans), has many people worried that the United States is inflating and spending itself into oblivion.
As with many popular notions about the economy, there is a mixture here of truth and misconception. The dollar has lost its value against other currencies, and we do have a current account deficit. But how much of this is bad news? A bit of an investigation into exchange rates and trade should clear away some of the haze.
Value and the Dollar
Why does the dollar have value? Since the last vestiges of the gold standard were eliminated in the early 1970s, the dollar holder cannot claim that the dollar is valuable because of its redeemability in gold. The dollar is usually made up of ones and zeros in bank computers, and at most it is just an unusually strong and decoratively engraved piece of paper. The “legal tender” statement on the dollar does not exert enough force to guarantee widespread acceptability—after all, people can still barter or use other currencies if they wish. In the United States, the dollar is useful for paying taxes, so the fact that dollars serve as “get out of jail free” cards around tax time is of some value. But there is more to the value of the dollar than that.
The dollar is valued because it is customarily accepted in exchange for goods and services. That customary attachment to the dollar has roots in the fact that it was once a substitute for gold, and gold itself was valued partly because it served the same purpose in monetary exchange. If we could go far enough back, we might see how the wide demand for gold as an ornamental metal made it unusually useful in exchange. At some point, gold changed from an ordinary commodity to a form of money—when its demand began to come from its wide acceptability in addition to whatever use it might have served.
The dollar becomes more valuable when more people around the world want to use it as money. To put this another way, the market value of dollars depends largely on how many other people are using dollars, just as the value of a fax machine depends largely on how many other people use fax machines.
For a long time, the U.S. economy has been a relatively large share of the world economy, and this makes it desirable to have dollars so that people can deal with the U.S. Not only do foreigners want to buy American goods and services, but also dollar-denominated assets (like U.S. corporate bonds and Treasury bonds). The stability of the dollar has contributed to this demand.
Compared to many other countries, the risk of inflation in the United States has been lower. When a foreign investor buys an American corporate bond paying 8 percent every year, he does not have to worry as much that inflation will sharply devalue the dollars being paid as interest and at maturity. There is of course some inflation in the United States, and it may get worse. However, foreigners are willing—to some extent—to take a hit on inflation so that they can have the dollars necessary to do business with people in the United States. The U.S. economy is friendlier toward business than much of the rest of the world, so that investments in the United States can be expected to perform relatively well.
The widespread desirability of trade with and investment in the U.S. allows the U.S. government to export more of its debt than would be possible otherwise. Not only do American corporations find it easier to sell dollar-denominated bonds overseas, but the U.S. government does as well. This means that the costs of America’s oversized government are harder for Americans to see. But the costs are still there.
Any government has three ways to raise money—taxes, borrowing, and inflation. The truth is that all three are taxation of one form or another. Borrowing is merely a postponement of the taxation, with the assurance that when the taxes are collected to repay the debt, they will be higher because of the interest paid to bond holders.
Inflation is a tax on dollar holders. Here is how the tax works. Imagine that there are four people in the economy, A, B, C, and D. Each has $250, so that the total money supply is $1000. Prices of goods and services in this economy correspond to this money supply. Now imagine that government enters the picture and creates a central bank. The government borrows $250 by issuing bonds, which are then sold to the central bank. The central bank buys the bonds by issuing $250 of newly created money, which is used by the government to pay for its purchases. Now the money supply is $1250, a 25 percent increase. Prices rise by about 25 percent. Whereas A, B, C, and D once each had 25 percent of the purchasing power in the economy, they now have only 20 percent each. They have the same number of dollars in their pockets but face higher prices. Twenty percent of their wealth has essentially been transferred to the government. No tax agent withheld taxes from a paycheck, or demanded payment by April 15. But the tax is there nonetheless.
Inflation is a particularly pernicious form of taxation because it is more easily hidden, or at least passed off as the responsibility of some other entity besides the government. When the Nixon and Ford administrations saw rising inflation in the United States, they blamed businesses and OPEC rather than the Federal Reserve. Price controls were their misguided response. Inflation also distorts the entire economy, creating the illusion that borrowing is cheap. Businesses respond to the lower interest rates by borrowing more to fund investment projects. When the central bank reduces its rate of money creation (as it eventually must if it wants to avoid hyperinflation), interest rates rise, and the once-sensible investment projects become unsustainable. Layoffs, bankruptcies, and the other earmarks of a recession are the typical consequence.
Finally, inflation is not subject to the usual legal constraints on taxation, and therefore is subject to even more abuses than other forms of taxation. While Congress has to go through a legislative process to raise taxes, the Federal Reserve can raise the “inflation tax” without such barriers. It is not clear that giving Congress influence over the Fed is the solution. In fact, international comparisons suggest that legislative influence over central banks only makes inflation worse. The legislators who spend money would love nothing more than to be able to pay for their excesses with a hidden tax.
The Costs of Borrowing
For years, American legislators have been able to sell substantial amounts of government debts to foreigners, largely in Asia.1 While this may make borrowing relatively attractive compared to inflation or current taxes, this does not mean that Americans have escaped the consequences of a big-spending government. When the government sells a bond, it is competing with private companies that also want to sell bonds to the same investors. By soaking up some of the available investment dollars, the government makes it harder for the private sector to borrow. Businesses have to offer higher interest rates to attract buyers for their bonds. Economists call this the crowding out of private investment, and it happens whether the buyers are domestic citizens or foreigners. Those Asian buyers of Treasury securities might otherwise have bought GE or IBM bonds.
A large part of the desirability of American investments has to do with the friendly environment for business in the United States. For many decades, the United States has been one of the freest economies in the world, and that has meant a high demand for American corporate bonds, American stocks, and other financial assets here. But the world is catching up. Large and small economies around the world have liberalized their economies, allowing markets to do their work. China, India, and the formerly communist countries in Eastern Europe are notable examples. These economies are not as free as the United States yet, but around the world, regulatory barriers to business are loosening. This increased freedom is certainly not a bad thing, but it does mean that unless the United States reduces its restrictions on business at a similar rate, the United States will have less of an advantage in the business environment. Globally, U.S. investment has more competition, and the U.S. dollar is losing its attractiveness relative to some other currencies, particularly the euro.
To get foreigners to buy a dollar-denominated asset like a Treasury bond, the U.S. government may have to start offering higher interest rates. Alternatively, the Federal Reserve could make the dollar more appealing by reducing the rate at which inflation eats away at its value. This is what Fed chairman Paul Volcker did in the early 1980s, and it worked.
Either way, there are problems in store. If the government offers higher interest rates, this will mean that the government can either tax more to pay the interest, or reduce its spending. If the Federal Reserve reduces its rate of dollar creation, the higher interest rates might trigger a recession. Depending on the magnitude of the interest rate increase, the recession might be quite significant.
Competitiveness and Freedom
A better way to maintain the desirability of trade with the U.S., and therefore maintain the value of dollars, would be to bring greater economic freedom to the U.S. economy.
But we find tremendous resistance to economic freedom. Economic freedom means American manufacturers would have to do without tariffs and other barriers to trade that protect them from foreign competition. Farmers would have to do without subsidies. College students and their parents would have to do without their federally subsidized student loans. Doctors would have to do without the restrictions on medical schools that limit the number of new physicians and thereby limit the number of their competitors. Academicians and scientists would have to seek funding or employment from the private sector instead of depending on government grants. Professional sports teams and their promoters would have to give up their subsidized arenas and stadiums.
With virtually everyone a beneficiary of some form of government intervention, even the slightest move toward freedom generates an outcry from some special interest that stands to lose. Economic freedom generates enormously improved well-being—the sticking point is that we all have to get our hands out of each other’s pockets. However, no one wants to remove his hand from the pockets of others if they still have their hands in his. What is needed is an overhaul of American attitudes toward freedom, and the will to reduce the intrusion of government wherever it may be found. Unfortunately, it is often crisis that brings about these sweeping changes.
Without comprehensive reform, the U.S. economy may lose its key role in the world’s economy, followed by a further decline in the dollar. The dollar’s slide may accelerate if there is a sudden change in confidence in the dollar’s continued acceptability.
A loss of confidence may occur if key markets in which dollars are the dominant medium of exchange switch to euros. Since a 1975 agreement with OPEC, the foreign oil market has been denominated in dollars, which means that countries that want to buy oil need to hold dollars, or at least dollar-denominated assets. This may change if the Euro zone has its way. William Engdahl suggests that a partial motivation for the Iraq war may be so that the United States can force the oil market there (and thus elsewhere) to continue to trade in dollars.2 In November 2000, at the inducement of the French, Saddam Hussein began to sell Iraq’s oil in euros. The switch set a precedent for similar action from others, and could have turned into a serious problem for the value of the dollar.
If major world markets and central banks begin using euros rather than dollars, the lower demand for the dollar will show up as a lower price of the dollar in currency markets. This “price” is just the exchange rate between dollars and another currency. A lower price of dollars means Americans will find that it takes more dollars to buy foreign goods and services. People who buy foreign goods (equivalent to “selling” dollars) will be less well off, and people who sell goods to foreigners (“buying” dollars) will be better off.
In general, a lower demand for the dollar will reduce the value of dollar-denominated assets, hurting those who hold those assets or depend on selling them to others. But not all the news is bad. The economic success of the United States has not resulted from the widespread acceptance of the dollar. As I have tried to show, the situation is quite the reverse. The dollar is widely accepted because the United States is a large, prosperous economy with which many countries wish to trade.
There is then no reason why the U.S. could not grow very rapidly even if the dollar loses its reserve currency status around the world. A recession might occur initially, if the marketability of dollar-denominated assets takes a hit. But we need not worry that the United States will be forever consigned to the economic backwaters of the world if the dollar loses its international standing. There are many countries that have expanded rapidly even without a widely demanded currency, such as postwar Japan, South Korea, and, more recently, China. There are other countries that have maintained at least respectable growth rates, such as many European nations, including some outside the Euro zone. Economic success depends less upon the acceptability of the government’s currency than upon how much the government has intervened in the market.
The Current Account Deficit
At the beginning of this essay, I mentioned the worries over the U.S. current account deficit. It is sometimes the case that a falling dollar is accompanied by a reduced trade deficit, or a trade surplus. This is because a falling dollar makes it cheaper for foreigners to buy American goods and more expensive for Americans to buy foreign goods. However, we have seen trade deficits in the United States that are quite high. This has contributed to the U.S. current account deficit, since the trade balance is the most important part of the current account.
Most of the worries over the trade deficit are misplaced. When Americans buy goods from foreigners, Americans provide them with dollars. Those dollars may be used in trade among other nations (e.g., in the market for oil), but if the foreign stocks of dollars are not to rise forever, they eventually must be brought back to the United States.
The trade deficit indicates that foreigners are not using their excess dollars to buy goods—otherwise there would be no deficit. So where are the dollars going? The only remaining possibility is that foreigners are using their dollars to buy American assets. That means stock in American corporations, bonds, real estate, and other assets. The availability of this capital means that the American economy can grow more rapidly.
In short, foreigners fund American businesses and locate their factories on American real estate, in exchange for which Americans get cars, electronics, clothing, and steel. Since American workers can use that foreign-provided capital, Americans benefit from higher rates of productivity—and higher incomes. Without trade deficits, the beneficial flow of foreign capital into the United States would stop.
The evidence supports the idea that trade deficits (and, it follows, current account deficits) are often good for growth. A Cato Institute study by Daniel Griswold3 suggests that when trade deficits increase, growth increases as well.
But a qualification is in order. Current account deficits mean that American firms are borrowing more from foreigners than foreigners are borrowing from Americans. This is a good thing if the borrowed funds are used to make productive investments, but a bad thing if the borrowed funds are used only to expand immediate consumption or unproductive investments.4 Just as there is a substantial difference between borrowing money to start a business and borrowing money to gamble in Las Vegas, the current account deficit can be a marker of a society on the rise or a society in deep trouble.
There is some reason to be concerned. Much of the American borrowing is being done by the U.S. government, which has racked up huge budget deficits in recent years. Part of the current account deficit, then, is being paid for with Treasury borrowing. Americans will eventually have to be taxed to pay for that borrowing, especially if a dollar decline raises interest rates and thereby makes it harder to “refinance” the government’s debt in the future. Yet the fact that foreigners continue to lend to Americans indicates that on the whole, Americans are probably using their borrowed funds wisely.
The key to maintaining economic prosperity in the United States is to appreciate Biblical limits on the power of government. Christians would do well to remember that there is blessing that follows keeping God’s commandments—including those that pertain to the civil magistrate. When individuals, families, and churches turn over inordinate amounts of power to the civil authorities, they are practicing a form of idolatry. This civil idol cannot save America or provide unlimited prosperity. To the extent that the dollar decline and the current account deficit are problems at all, they are problems created by an idolized government that has lost its boundaries.
1. China is the second-largest holder of U.S. government debt. On this and the U.S.-China exchange rate controversy, see Daniel Ikenson, “Currency Controversy: Surplus of Politics, Deficit of Leadership,” Cato Institute Free Trade Bulletin No. 21, May 31, 2006.
2. F. William Engdahl, “A New American Century? Iraq and the Hidden Euro-Dollar Wars,” Current Concerns, no. 4 (2003).
3. Daniel Griswold, “Forget Trade Deficits: Go for Growth,” Cato Institute Commentary, February 25, 2005.
4. See Stefan Karlsson, “What Are We to Make of the Trade Deficit?” Ludwig von Mises Institute Daily Article, March 21, 2005.