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18 Oct 2013

No alternative to the dollar

Stephen King

by Stephen King

HSBC Group Chief Economist

No alternative to the dollar (Getty Images/L. Toshio Kishiyama)

There is a danger of a mismatch between America’s fiscal ambitions and the interests of its creditors

Can you hear the sound of cans being kicked down the road? The US disaster scenario has been avoided, for now. But given the deep disagreements between Democrats and Republicans and the even deeper divisions within the Republican party, we may end up going through the process all over again early next year.

If it had been any other country than the US, we’d all have had a good laugh before putting our money elsewhere. The guilty nation would have faced a much higher cost of credit and a much weaker currency.

Because, however, the US dollar and treasuries provide the anchor for the global financial system, we merely breathe a sigh of relief and keep our fingers crossed that, next time, a deal will be struck without too much blood being spilt.

That may be a forlorn hope. Many Republicans voted Wednesday night in favour of default. Some, it seems, are prepared to play a financial version of Russian roulette, thinking that a default need not lead to disaster – in the same way that, five times out of six times, pulling the trigger does no harm. Others have regarded the recent federal government shutdown as a way to demonstrate the case for small government. They might be willing to do the same thing all over again in a few weeks’ time.

There are also some more serious undercurrents. One is the persistent absence of decent economic growth. During the 1980s and 1990s, the US economy happily chugged along at 3-3.5 per cent a year. Since 2000, the pace has slowed to an annual rate averaging around 2 per cent. Even though, this year, the budget deficit has ended up lower than expected, the longer-term fiscal arithmetic is, to say the least, discouraging. Unless Congress grapples with this challenge now, the fiscal debates will become even more protracted in years to come. The US will end up being either a high tax or low-spending economy. Reaching agreement on which will be, to say the least, difficult.

If it had been any other country than the US, we’d all have had a good laugh before putting our money elsewhere

The second, related issue, is the incredibly high level of income inequality in the US. John F Kennedy used to claim that “a rising tide lifts all boats” but, in modern-day America that aphorism no longer seems to work. The gap between “haves” and “have-nots” has become ever larger, and the number of haves has got ever smaller: even wages for university graduates have, in many cases, struggled to keep pace with productivity gains. What role should government play in this story?

Some think it should be more than happy to redistribute slices of the economic cake. Others take a more 19th-century view, arguing that, because the rich tend to save more, they are better able to provide the funds for long-term investment that might, otherwise, be squandered to buy votes.

The third issue is America’s financial relationship with the rest of the world. The battles witnessed in Washington over the last few weeks suggest that at least some US politicians have lost sight of the fact that the US is heavily indebted to the rest of the world.

Reserve currency status helps keep the creditors at bay – the costs of walking away from a dollar-based global financial system are possibly greater for America’s creditors than they are for the US itself – but reserve currency status also allows Washington to slip into bad habits that no other country could ever contemplate.

Even if the debt ceiling is raised, even if further shutdowns are avoided, there is a danger of a growing mismatch between America’s own fiscal ambitions and the interests of its creditors.

It’s not quite the same story but the early-1970s break-up of the Bretton Woods system of fixed but adjustable exchange rates provides an intriguing precedent. The mounting costs associated with the Vietnam war led US authorities to crank up the printing of dollars in the late-1960s.

While this helped alleviate domestic fiscal pressures, the extra dollars in circulation threatened the dollar’s supposedly fixed link with gold. Foreign central banks began to fret, swapping their dollar reserves into precious metal, leaving US gold reserves precariously low.

Eventually, the growing inconsistency between US political ambition and global financial need led to the Bretton Woods system collapsing altogether, paving the way for the financial chaos of the 1970s.

Ironically, the current budgetary mess has also encouraged the printing of dollars. The Federal Reserve’s decision in September not to taper seems, in hindsight, to have been remarkably prescient. With the countdown to another potential debt ceiling stand-off already under way, it may even be tricky for the Fed to contemplate tapering in December.

The extra liquidity associated with quantitative easing has already triggered financial upheaval elsewhere in the world – most obviously in some of the more fragile emerging economies – but a further attachment to quantitative easing in a bid to mask Washington’s fiscal dispute may only encourage further problems down the road.

It may often seem that there is no alternative to a dollar-based international financial system. There is. It’s called financial chaos. The deal struck this week is more than welcome. The risk of financial chaos, however, has not yet gone away.

This article originally appeared in the Financial Times on 17 October.