While it’s nice that President Bush is worried about a Social Security crisis scheduled to hit in 36 years, I’d personally prefer he tackled the fiscal crisis we’re facing now. Because of irresponsible tax cuts and runaway spending increases, Manhattan’s national debt clock — which was turned off when it started going backward during the closing years of the Clinton administration — is now scrolling forward at $400 billion a year. This massive debt has, in turn, decreased America’s net exports and spurred the current account deficit to new highs, causing the dollar to slide against every major global currency.

Suhael Momin

The United States, which emerged from World War II as the only major capitalist power, was instrumental in the reconstruction of international financial markets. Because the Bretton-Woods framework of fixed exchange rates was anchored by the American dollar, the dollar quickly emerged as the dominant trading currency. Even after the Bretton Woods system collapsed and most of the world’s major currencies were allowed to float freely, the U.S. dollar remained the preeminent medium for international transactions and commerce, and foreign governments were effectively required to hold billions of American dollars in reserve. This position of prestige kept the dollar stable and strong and allowed the American government to run significant budget deficits — foreign central banks were eager to finance American spending and acquire dollar-denominated debt.

The exploding current account deficit — it topped $600 billion last year — has unsettled this comfortable arrangement. The current account, which measures the net exports balance, has a direct bearing on the dollar’s exchange rate, which in turn determines whether foreign central banks are willing to take on U.S. Treasury securities and accommodate American government debt. The mechanism is simple: Americans must buy foreign currency to buy foreign goods, so if Americans buy $600 billion of foreign goods in excess of American exports, the global supply of dollars increases by $600 billion. The international financial markets operate on the same principles as those described in Econ 101 — if the supply of dollars increases by $600 billion, the price, measured through the exchange rate, drops. This drop is accompanied by consequences: The New York Times reports that the European Central Bank had real losses of $625 million due to depreciation in 2003 and about $1.3 billion in 2004. Facing these losses, foreign central banks are less likely to hold dollars or dollar-denominated debt.

The emergence of the Euro has exacerbated this problem. In the past, foreign governments were forced to hold American dollars to engage in international trade. For the first time since Bretton Woods was instituted in the 1950s, the American dollar is in a position to lose its status as the world’s dominant reserve and trading currency. Used in the world’s most active trading zone and managed by one of the world’s most respected reserve banks, the Euro is a commonly used and stable alternative to the U.S. dollar. If the dollar continues to slide, the pressure on central banks to shift portfolios into the Euro will only increase.

America finds itself at the edge of a cliff; further fiscal profligacy could push the American economy into crisis. If foreign banks, which are already expressing concern over holding American government debt, decide not to take on additional dollar-denominated assets and the stream of money financing irresponsible government spending dries up, the interest and inflation rates facing American consumers and investors will inevitably increase. The American economy, which is still bound by the fundamental laws of economics, could easily plunge into recession.

Given America’s increasingly precarious position in the international financial market, it’s hard to find a rationale for the administration’s policy direction. Divorced from economic reality, Bush has proposed a drastic overhaul of the Social Security system that would require trillions in borrowing. His massive Medicare prescription drug benefit, which will cost hundreds of billions over the next decade, was passed without any provisions to generate the revenue needed to finance it. He has even urged Congress to make permanent his first-term tax cuts, slated to expire at the end of the decade, at a cost of trillions more.

The Bush administration’s gargantuan budget deficits threaten the dollar’s prestigious position in international currency markets and America’s ability to secure cheap loans from foreign creditors. At a time of war and increasing entitlement costs, Bush’s politically expedient and dogmatic dedication to tax cuts and aversion to any form of tax increases threatens the fundamental economic health of this nation. In the end, even though Shadow President Dick Cheney might have argued that Reagan proved deficits don’t matter, the laws of economics continue to dictate otherwise.


Momin can be reached at smomin@umich.edu.

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