The Dollar and the Deficits: How Washington Can Prevent the Next Crisis

by C. Fred Bergsten, Peterson Institute for International Economics

Article in Foreign Affairs, Volume 88 No. 6, November/December 2009
November 2009

Even as efforts to recover from the current crisis go forward, the United States should
launch new policies to avoid large external deficits, balance the budget, and adapt to
a global currency system less centered on the dollar. Although it will take a number
of years to fully implement these measures, they should be initiated promptly both to
bolster confidence in the recovery and to build the foundation for a sustainable US
economy over the long haul. This is not just an economic imperative but a foreign policy and
national security one as well.

A first step is to recognize the dangers of standing pat. For example, the United States’
trade and current account deficits have declined sharply over the last three years, but
absent new policy action, they are likely to start climbing again, rising to record levels
and far beyond. Or take the dollar. Its role as the dominant international currency has
made it much easier for the United States to finance, and thus run up, large trade and
current account deficits with the rest of the world over the past 30 years. These huge
inflows of foreign capital, however, turned out to be an important cause of the current
economic crisis, because they contributed to the low interest rates, excessive liquidity,
and loose monetary policies that—in combination with lax financial supervision—brought
on the overleveraging and underpricing of risk that produced the meltdown.

It has long been known that large external deficits pose substantial risks to the US economy
because foreign investors might at some point refuse to finance these deficits on terms
compatible with US prosperity. Any sudden stop in lending to the United States would drive
the dollar down, push inflation and interest rates up, and perhaps bring on a hard landing
for the United States—and the world economy at large. But it is now evident that it can
be equally or even more damaging if foreign investors do finance large US deficits for
prolonged periods.

US policymakers, therefore, must recognize that large external deficits, the dominance of the
dollar, and the large capital inflows that necessarily accompany deficits and currency
dominance are no longer in the United States’ national interest. Washington should welcome
initiatives put forward over the past year by China and others to begin a serious discussion
of reforming the international monetary system


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