Americans have long been warned that running large, continuous deficits courts disaster. ‘We are living on borrowed money and borrowed time’, was the way Walter Mondale put it to the 1984 Democratic Convention, when the us government’s cumulative deficit was some $7 trillion less than it is today. Three years later, a spate of cartoons and op-eds would depict the 1987 stock-market crash as a vicious hangover; the just deserts of a wastrel nation. The ever-accumulating deficits so frightened the first President Bush that he famously reneged on his ‘read my lips’ promise not to raise taxes. In 1992, Ross Perot launched the most successful third-party presidential candidacy since Eugene Debs by making the rivers of red ink his central campaign issue. Clinton’s great boast was that he managed temporarily to close the government deficit, although the trade deficit continued to grow during his administration.
It was not supposed to work that way; the government deficit had long been understood as a prime cause of the trade deficit. But before the puzzle resolved itself, George W. Bush arrived in Washington and, with his tax cuts, wars and lavish spending directed at his electoral base, ripped open the sutures that the Clinton administration had stitched between us government spending and tax revenues. Both the government and trade deficits soon reached levels that would have been regarded as inconceivable by most economists a few years before. Doomsayers extended far beyond the ranks of Democrats and old-school fiscal conservatives; at the beginning of 2005 Warren Buffett announced that he was so scared by the deficit trends that he was largely going to quit buying stocks or bonds denominated in dollars.footnote1 At the Davos Forum that year, C. Fred Bergsten of the Institute for International Economics warned of a dollar crisis ‘within weeks’.footnote2 In a widely reported speech at Stanford a month later, Paul Volcker, former chairman of the Federal Reserve, spoke of an economy ‘skating on thin ice’.footnote3 With beleaguered Republicans dependent on low taxes and government largesse to remain in power, and Democrats unelectable on an explicit programme of higher taxes and spending cuts, these men saw no plausible scenario other than a dollar crash for any reversal in the ever-growing-deficit trends. At some point, the foreigners who help finance the two deficits would surely refuse to throw more good money after bad. They would dump their dollar holdings, leading to a crash in the dollar that would finally force Americans to live within their means.
But none of this has happened. The markets reacted to the doom-saying with the insouciance of a dog shaking itself dry. By the end of 2005 the dollar stood 15 per cent higher against the euro, 13 per cent higher against the yen, than it had in January; and this during a year when both government and trade deficits continued to set new records practically every month. Hence the conundrum: the savviest observers pronounce the trend lines of the deficits to be unsustainable; no realistic scenario can be imagined under which those trends will be reversed through political action, leaving only a dollar crash to do the job; yet the dollar crash stubbornly refuses to occur. Keynes once compared the stock market to a beauty contest in which the winnings went to whoever could pick the contestant thought by the other judges to be the most beautiful. If this is true of stocks, it is emphatically the case for currency markets. The day is long gone when the ebb and flow of international trade determined the value of currencies. Daily volume on the world’s foreign-exchange markets runs in the trillions of dollars, with the us dollar bought or sold in roughly 85 per cent of all currency trades—most of them speculative. If enough people believe that enough others will hang on to the dollar come what may, then the dollar will not fall, whatever happens to the us deficits.
There is no secret about the identity of the biggest dollar holders. They are the central banks and other financial institutions of Japan, China, South Korea, Taiwan, Hong Kong, Saudi Arabia and the Gulf Emirates. If the dollar is going to crash, one or more of these places is going to have to change its stance towards the American currency. They display such a seemingly reflexive commitment to accumulating and retaining dollars that some commentators have described the current global financial order as ‘Bretton Woods ii’—a continuation by other means of the dollar-centred international order that prevailed in the postwar decades. The label does not itself explain why these states behave as they do. But it suggests that, for whatever reason, they have motives other than maximizing returns on their foreign-currency holdings; that they have a vested interest in the continuation of a us-led financial system.
The Bretton Woods system conceived by Keynes and Harry Dexter White in 1944 was more than a simple recognition of the reality that the United States would emerge from the Second World War in a position of overwhelming economic strength and that any workable global financial regime had to start from that premise. It mandated specific institutional action and imf approval to reset the exchange value of any currency in the system vis-à-vis the dollar. Most importantly, it required that the us maintain both the will and the ability to sell gold at $35 an ounce to foreign central banks on request, which meant that Washington had to take action whenever trade deficits threatened a precipitous loss of gold. When in 1971 the Nixon administration suspended the gold sales, did not use economic tightening to reverse the structural trade deficits, and could neither persuade nor browbeat its trading partners—notably Japan—to undertake compensating adjustments, the system collapsed. But despite a decade that saw the exchange value of the dollar plummet, the financial world continued to revolve around the dollar and does so to this day.
There is every reason for the us to be happy with Bretton Woods ii since Americans reap vast benefits from the arrangement, most importantly in the ability to finance trade deficits with impunity—what French economist Jacques Rueff famously labelled ‘deficits without tears’. Among other things, that allows Washington to project military power around the world at little real financial cost, since the necessary money is first created by the Federal Reserve, then exchanged for goods and services from foreigners, and borrowed back by the us Treasury.footnote4 (Technically, it does not matter in what form foreigners hold dollars, whether us government debt, corporate debt, equities or anything else with a $ sign. As long as the securities are denominated in dollars they remain within the American banking system, where they serve to create credit in the us.)
But if the benefits to the us in Bretton Woods ii may be obvious, the benefits to those who prop it up are much less so. Indeed, the system is curious in at least two ways: unlike Bretton Woods i, there is no formal institutional requirement on anyone to support it; and adjustment burdens have generally been shouldered not by the system’s primary beneficiary—the us—but by its creditors. To be sure, Volcker put the American economy through a recessionary wringer in 1979, bringing inflation down and thereby slowing the precipitous decline in the purchasing power of the dollar that had set in after the collapse of Bretton Woods i. The first Bush administration raised taxes, while the Clinton administration succeeded in producing a balanced Federal budget. But the us would have needed to take these sorts of measures anyway. Washington was not acting disinterestedly to save a global system, but rather to head off runaway inflation and economy-crushing interest rates. On the other hand, Japan’s support for the dollar was a major cause of the 15 years of deflation and low growth it endured after 1990, while lower-income China used savings extracted from its impoverished citizens to finance American consumption.