The Dollar Crisis: Causes. Consequences and Cures
TCAS Raghavan ·       

The author is a former employee of Salomon Brothers and has worked for the World Bank. As such he knows what he talking about. And he is worried that, thanks to the way in which the US finances its expenditure, the rest of the world is building up a huge stock of dollars. This, he says, will eventually lead to a global deflation as the US finds that it can no longer sustain its expenditures and the dollar holders find that their reserves are depreciating. Since some of this has already begun to happen, the book is an especially prescient one. It may well become a classic of sorts.

Duncan?s starting point is the same as the one that led to the breakdown of the Bretton Woods System, namely, the flood dollars. Between 1945-71 Bretton Woods era, international reserves expanded, going up by a mere 55 per cent. Since then, total international reserves have gone up by more than 2000 per cent. Today, Asian central banks alone hold approximately $1.5 trillion. The significance of this has not yet been fully realised by the world, says Mr Duncan because the dollar standard has also led to potentially disastrous consequences.

At the bottom of it all is the US current account deficit, which says Mr Duncan, is increasing at the rate of a million dollars a minute. This year alone the US current account deficit will be $500 to $600 billion. The dollar standard, which replaced the gold standard in 1971 when the US refused to honour its gold commitments to the rest of the world has allowed the rest of the world to sell its products to the US on credit. This has created macroeconomic imbalances, which will end up destabilising the global economy. Basically, so much liquidity means low interest rates. Low interest rates mean easy investment decisions. Easy investment decisions mean too much investment in the wrong things. The result is over-capacity. And over-capacity means falling prices. Falling prices mean deflation. Deflation means falling incomes. Falling incomes mean crisis. QED.

If the outcome is going to be a painful one, the process of getting there is no less painful. The effect on the economy is just the same as if the central bank of that country had injected high-powered money into the banking system. Accumulating too many dollars has meant, first, sharp and sustained increases in asset prices, and then the reverse. Both Japan and East the Asia have gone though this cycle and are still to recover from it. China, with its nearly USD 200 billion in reserves may well be next in line.

Thailand, which triggered off the Asian crisis of 1997, is a perfect example of what can and did happen. Between 1986 and 1996, credit in Thailand expanded at 25 to 30 per cent a year. Towards the end, much of it went into highly risky investment and the bubble burst in 1997. Exactly the same thing happened in all the other countries that built up huge dollar reserves.

The problems begin when the dollar begins to depreciate, as it is now. Attempts to convert even a small portion of the dollar reserves into gold would drive the price of gold higher. Ditto for the Euro, which, too, is happening. Indeed, the stock market revival in India is mainly because of the new dollars that are coming into the market as the FIIs look for investment opportunities.

Clearly, the limits for alternative investments are low. This means that international dollar reserve holdings can be put only in US dollar-denominated assets in the US. The surplus nations will have to find places to invest that around USD 500-600 billion in dollar-denominated assets. But while this allows the US to finance its deficit, it also creates the pressure of repayment. When the time comes the US may well refuse, as it did in 1971 with gold, or allow its currency to depreciate, as it is doing now.

One way or the other, the rest of the world in the doldrums because the US owes the rest of the world approximately $3 trillion. This is 30 per cent of its GDP. The rate of increase is approximately USD 500 billion a year, which is 5 per cent of GDP. This will go on well into the future, until a sharp fall in the value of the dollar happens or when the US goes broke. Then the balloon will truly go up. But it is difficult to tell which will happen first.

Will all this really happen? Does economics have such precise causality? Karl Popper once asked a simple question. Does the fact that all the swans that you have seen are white mean that all swans are white? That is, could it not be that there is at least one swan that you have not seen, and that it is not white? This has important implications for macroeconomics and its management. For example, does the fact that all fiscal deficits that IMF economists have seen (because they are called in only when there is a crisis) been associated with major crises mean that all fiscal deficits lead to crises? Is it all right to make a giant leap from a few observed particulars to a universally valid generalisation? Time will tell.