Global Policy Forum

By Steve Liesman

When economists these days consider the risks to their rosy 2004 economic forecasts, one rises to the top of the heap: a dollar crisis. The worry isn't about the depreciating dollar; an orderly decline doesn't keep economists up at night. (Just because a currency weakens doesn't mean there's a crisis.) The concern is about a sharp revaluation, a morning when the holders of dollars around the world awake with a sudden distaste for the flavor of the greenback. The fallout could be nasty: a Treasury auction that goes poorly, requiring a much higher interest rate to place the bonds, bank defaults and other stresses on the global financial system.

So I decided to find someone who understood all this stuff and hooked up recently with Robert Mundell, the 1999 Nobel Prize winner in economics who is called the father of the euro for his work in the 1960s that led to European Monetary Union. (Actually, that's not quite true. I've been trying to hook up for months with Prof. Mundell, ever since the dollar started weakening this summer. But the septuagenarian has been around the world three times in the past three months and Monday was the only time he could squeeze me in.) We met in his cramped apartment near Columbia University, where he's been a professor of economics for the past 25 years. There was a lot for us to talk about, like the dollar, and whether the Bush administration should really be pressuring China to revalue its currency, the yuan.

For a brief moment, my concerns were eased. Prof. Mundell doesn't foresee a rapid dollar decline next year. "The growth of the economy, as it swoops forward next year at a 4% growth rate -- the dollar will recover and I think the Euro will drop down to $1.05," he says. (One euro currently buys about $1.23.) But Prof. Mundell's confidence weakens sometime after that. He sees a crisis on the horizon, if not next year, then soon after. He's a bit like an earthquake predictor -- he's sure the crisis is coming, but just can't pinpoint the year.

The focus of his concern is the current-account deficit, the general measure of how much more we spend than we produce. This has been hovering around record levels recently, north of 5% of gross domestic product, or total output. In dollar terms, it's about half a trillion dollars annually, or about $1,800 for every American. All of that adds up to our cumulative U.S. debt outstanding to the rest of the world. "That was a problem in the 1980s, but it's worse now because in the '80s, the U.S. was a net creditor country and now it is a debtor country," Prof. Mundell told me. "The U.S. debt is something like $3 trillion dollars, almost 30% of gross domestic product. So this is a major problem, not immediately, and not this current cycle, but its a problem people will be anticipating over the next few years." - "What it means is that as a percentage of GDP, it will be 35% next year, eventually 40% and then at some point it is an accident waiting to happen -- a big international crisis." (My emphasis added.)

You should know that Prof. Mundell is a member of the supply-side club that supports tax cuts as a way to stimulate economic growth and increase the pie from which these debts are paid. Yet this happens at the expense of a growing federal budget deficit that contributes to the nation's mounting debts to the world. To the extent that we borrow from abroad to fund it, which has increasingly been the case, it raises our foreign indebtedness.

I hate to quibble with a Nobel prize winner, but the one flaw in his theory is this: if markets were able to forecast a coming dollar crisis, they would be just as likely to trade on it today. So it seems to be a bit of wishful thinking that markets aren't looking at the same numbers and aren't coming to the same conclusion. Rather than acting later, they would act sooner.

I think it's particularly worrisome in light of the recently adopted prescription-drug plan. I'll confess to not knowing the details, but the overall picture is unmistakable: we've adopted a $400 billion new federal spending program with absolutely no way to pay for it. In light of paltry U.S. savings rates and the aging of the population, it will be foreigners who will be asked to fund this new benefit. A South American sitting in Patagonia holding dollars just got a slap in the face: we've told him that our answer to the coming wave of baby-boomer retirements is to print more dollars and sell more bonds. That's not an inspiring development for a creditor.

For some perspective on the worries about a dollar crisis, I called Martin Bailey, President Clinton's former economic advisor. His take, curiously, echoes recent comments by Treasury Secretary John Snow, that the dollar may have declined but it remains relatively overvalued. Some decline is likely and may be slightly inflationary, he said, but would come at a time when we need a little inflation. "This is a pretty good time to take a downward adjustment to the dollar," he said. Yet, he agreed, "The one scenario that we used to worry about in the Clinton administration is whether, if you got an abrupt fall in the dollar, that would trigger higher interest rates, disrupt the stock and the housing market and put some pressure on financial institutions."

He called it a "worrisome scenario" but not one he views as likely. Investors world-wide have to work out this problem: when foreign investors don't like dollars any more, what will they like? We have net inflows into this country because the investment opportunities are judged by investors and central banks in Japan, Europe and China to be more attractive than those in their own countries. The question is whether they continue to be drawn to the U.S. as a place to put their money, and for how long?

Prof. Mundell says the way not to fix this problem is by pushing China to revalue its currency, which Beijing keeps fixed to the dollar, and which the White House would like to see float freely against other currencies. He sides against the Bush administration and with Fed Chairman Alan Greenspan, who argued recently that a more expensive Chinese currency wouldn't bring any manufacturing jobs back to the U.S., but simply shift the Chinese jobs to other low-wage nations. "It's not a good idea for China and it would derail its growth…. And it would not be good for the world economy. It would impede China's ability to do all those things to comply with the World Trade Organization," Prof. Mundell said. A hypothetical 40% devaluation in the yuan, he notes, would do little to bridge the wide disparity between U.S. and Chinese wages.

Prof. Mundell's solution isn't surprising for an advocate of monetary union: it's fixing exchange rates between the yen, the dollar and the euro -- a step on the way to currency union. It's a controversial idea that critics pounce on, noting that the discord in Europe between 12 countries over its existing monetary union, and the United Kingdom's inability to decide if it will join that same union. (Not to mention currency crises in Mexico and Argentina, countries that had fixed their currencies to the dollar.) And the concept of fixing the dollar to the euro or the yen is probably a political non-starter at best. Unless, that is, the hands of government officials are forced. "Big changes in the international monetary system usually occur because of big events, crises, and war often leads to it," Prof. Mundell says. "I hope that wouldn't lead to the next one. But it could be a crisis of the dollar or recognition that the dollar could be in a crisis if we don't do anything about the international monetary system."

What Prof. Mundell says about a coming crisis makes sense if the current-account deficit continues to grow, the dollar continues its freefall and if the leaders of the industrialized world don't come together to reassure markets. And how they reassure markets is likely to put a floor under the greenback, which isn't a fixed exchange rate, but is part of the way there. So Prof. Mundell's ideas may not be so far out. After all, he was a visionary in the 1960s, even if it took the world 30 years to realize that vision.

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