Economics

Two Dollar Fallacies

Feb 28, 2013 Martin Feldstein

One frequently hears two key arguments from economists who dismiss the fear of a run on the dollar: the dollar is a reserve currency, and it carries fewer risks than other currencies. Unfortunately, neither argument is persuasive.

CAMBRIDGE – The United States’ current fiscal and monetary policies are unsustainable. The US government’s net debt as a share of GDP has doubled in the past five years, and the ratio is projected to be higher a decade from now, even if the economy has fully recovered and interest rates are in a normal range. An aging US population will cause social benefits to rise rapidly, pushing the debt to more than 100% of GDP and accelerating its rate of increase. Although the Federal Reserve and foreign creditors like China are now financing the increase, their willingness to do so is not unlimited.

Likewise, the Fed’s policy of large-scale asset purchases has increased commercial banks’ excess reserves to unprecedented levels (approaching $2 trillion), and has driven the real interest rate on ten-year Treasury bonds to an unprecedented negative level. As the Fed acknowledges, this will have to stop and be reversed.

While the future evolution of these imbalances remains unclear, the result could eventually be a sharp rise in long-term interest rates and a substantial fall in the dollar’s value, driven mainly by foreign investors’ reluctance to continue expanding their holdings of US debt. American investors, fearing an unwinding of the fiscal and monetary positions, might contribute to these changes by seeking to shift their portfolios to assets of other countries.

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Martin Feldstein

Writing for PS since 2008
130 Commentaries

Martin Feldstein was Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. He was also on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

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William Wallace Mar 10, 2013

The article ignores the political aspect. Many will continue to keep dollars based on the political stability of the country backing it. The euro is a long way from that, and there are few other viable contenders. The worse things are, the safer the perceived refuge, as the last several years have shown.
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Basle Jean-Luc Mar 4, 2013

A run on the dollar is possible but unlikely. Two conditions would have to be met: a) the United States would have to show an unwillingness to reduce its budget deficit and b) dollar investors would have to have another liquid asset in which to transfer their holdings. Neither of these conditions has been met. The sequester, senseless as it is, has been activated and the fate of the euro, the only currency likely to attract investors, is very much in doubt, especially after the Italian election. Martin Feldstein’s opinion on entitlements is known. Resorting to scare tactics to defend his point of view only hurts his image. One final point: the accumulation of dollar reserves is the logical consequence of these countries’ mercantilist policies, first among them China.
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The PolyCapitalist Mar 1, 2013

"countries like South Korea, Taiwan, and Singapore"

Dr. Feldstein,

Your Harvard colleague, Joe Nye, who also writes for Project Syndicate, can perhaps help explain why two of three countries you mention might have reasons beyond economic ones to hold U.S. dollars.

How likely are S. Korea and Taiwan to dump their U.S. dollar holdings given their dependence on the U.S. security blanket? Not very.

This article is another great example of how narrow economic thinking leads to incomplete analysis.
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Patricia Flanagan Mar 1, 2013

This article should be called two debt fallacies. First of all a sovereign country whose foreign debt is denominated in its own currency can repatriate its foreign debt at any time without consequence to interest charged on that debt. The US government sets the interest rate on its government bonds and as such is a market maker in the true sense of the word. The US government can never and would never fall victim to foreign bond vigilantes.
If foreign bondholders or dollar holders did decide they wished to hold less american dollars or bonds, the dollar would of course depreciate against other currencies.
The challenge for foreign dollar and bond holders under these circumstances would be a depreciating asset as well as appreciating domestic currencies which would undermine their exports. Exporting countries are not holding the american dollar as a reserve currency but as a means to maintaining their competitive advantage as exporters. your article offers no compelling reason for exporting to abandon a strategy that is so obviously working for them.
Second, this article laments the decline in the dollar and the large current account deficit as though these phenomena are not inextricably linked. Choose you poison, lower exchange rate on the dollar=smaller trade deficit , or higher exchange rate = larger trade deficit. The real threat to the economy is not debt levels at the domestic level but arguments for austerity based on false premises.
- Matt Russo Apr 11, 2013
  
  "Exporting countries are not holding the american dollar as a reserve currency but as a means to maintaining their competitive advantage as exporters."
  
  This is tantamount to stating that the USD does not in fact function as a "reserve currency". Was that the intention?
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Terry O Feb 28, 2013

Hi, a well thought out article but I'm having troubles linking the arguments to the thesis. Are you writing about why the dollar is expected to fall or why is the current fiscal and monetary policies unsustainable?

You highlighted that perception of a risky dollar and dollar bonds could cause a decline in dollar due to foreign economies potentially seeking to reduce holdings of US Treasuries, and investors seeking to diversify away from the dollar. Isn't that true for everything else? What's important is what would cause the dollar to receive such negative perceptions.

Todays yield reflects the demand or lack of demand of dollar bond issues but tells us little about tomorrow's demand. If this increase in bond yields persists and translates to increase in asset yields, now, this yield would actually attract demand for dollar assets and dollars in return. So there exists a counteractive force for the value of dollar which would eventually settle.

Unless I am seeing it all wrongly, I guess I am having seeing past the tautology present in the article.
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