A massive fiscal stimulus and, until recently, aggressive monetary easing have been successful in raising bond and real estate prices to unprecedented levels, inducing a credit boom that has prevented private consumption from falling. While it might still be too early to say that it worked, the strategy has indeed, for the time being, prevented the U.S. economy from slipping into a severe depression after the collapse of the stock market at the turn of the millennium.

Korkut A. Erturk

English

Research Papers in Economics

The Levy Economics Institute of Bard College
Policy Note
2005 / 3
IS THE DOLLAR AT RISK?
 .  
A massive fiscal stimulus and, until recently, aggressive monetary easing have
been successful in raising bond and real estate prices to unprecedented levels,
inducing a credit boom that has prevented private consumption from falling.
While it might still be too early to say that it worked, the strategy has indeed, for
the time being, prevented the U.S. economy from slipping into a severe depres-
sion after the collapse of the stock market at the turn of the millennium.
But, in the meantime, the aggregate macroeconomic imbalances have clearly gotten worse
(Papadimitriou et al. 2005). The budget deficit has risen steadily every year in the last four years
and was estimated to exceed $400 billion in 2004. The current account deficit is already well in
excess of 5 percent of GDP. The value of assets owned by foreigners in the United States has by
now reached $3.3 trillion, almost 30 percent of GDP, and is double the share of four years ago.
This amount now exceeds what Americans own in the rest of the world, and net investment
income—interest plus dividend payments—will increasingly turn negative for the United States
as interest rates go back up in the future.
There has been some improvement in the level of indebtedness in the corporate sector in the
last few years, but households’ indebtedness remains at an all-time high. The saving rate out of
household disposable income is barely positive, and the overall national saving rate is slightly
above a minuscule 1 percent of GDP. The weakening of the dollar, about 16 percent on a broad 
Research Associate Korkut A. Ertürk is an associate professor and chair of the University of Utah Department of Economics.
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discussion
on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the author.
Copyright © 2005 The Levy Economics Institutetrade-weighted basis since its peak in February 2002, shows no
sign of having any real impact on the current account deficit,
making one wonder how much further the dollar can decrease
without triggering a sharp rise in U.S. interest rates.
The Dollar: A Bleak Outlook
Technically, an even weaker dollar could allow the U.S. econo-
my to expand at the expense of the Asian and European
economies (Godley et al.2004).But,if that meant higher inter-
est rates, the level of private consumption in the United States
could not possibly maintain its current level,and a severe reces-
sion would surely result.Given the high level of indebtedness of
the household sector, the negative impact of sharply higher
interest rates on private consumption would be considerably
stronger than the positive impact on exports stimulated by the
lower dollar.
What happens to interest rates in the United States as the
dollar continues to lose value depends on the degree to which
the foreign demand for U.S. financial assets slackens.A drawn-
out, gradual weakening of the dollar would make U.S. assets
less and less attractive for foreign investors, and would sooner
or later push up their yields to levels that can more than com-
pensate for the higher devaluation risk they now possess. In
fact, within the last year, net private capital flows have almost
consistently remained below $57 billion, the average monthly
U.S. current account deficit, requiring official purchases to
make up the difference.For all intents and purposes,the United
States is now dependent on a handful of foreign (mostly east
Asian) central banks to attract enough capital to cover its for-
eign deficit.
Arguably, a steep dollar devaluation, rather than a slow
downward drift, would be better for the U.S. economy, as it
would wipe out the devaluation risk of U.S. assets in one fell
swoop, making them cheap and attractive to foreign buyers
once again.Moreover,the net asset balance of the United States
vis-à-vis the rest of the world would also improve considerably
after a maxi devaluation. But it is doubtful that the United
States would be able to bring about an abrupt devaluation, even
if it wanted to,short of causing a complete financial breakdown.
Barring cataclysmic events, it appears that what will happen to
the dollar and U.S. interest rates in the near future will increas-
ingly be dictated by the interests of foreigners, such as the
Chinese and other Asians, who are already in possession of a
massive cache of U.S.dollars.This means that the United States
will find it increasingly difficult to maintain any real control
over its financial and economic destiny.
A Structural Conundrum?
Given this structural bind, it is possible to speculate about
three distinct scenarios for the near future. First, against all
odds, the economic recovery takes hold in the United States,
and the world economy settles on a path of sustainable growth.
The United States would then resume being the engine of
world growth by continuing its role as the importer of last
resort,and exports could continue to lead aggregate demand in
much of the rest of the world. The twin deficits would then
cease to be a problem: the current account deficit would be
equity financed by private foreign investors, and the budget
deficit would,over time,simply shrink—in ratio to GDP,if not
in absolute level—with higher output growth.
The second possibility is a complete collapse of the dollar
and cataclysmic turmoil in financial markets worldwide. This
could occur if, for some unexpected reason, financial panic
overwhelmed the ability of world central banks to absorb a
massive worldwide dollar sell-off. Thus, even if no one desired
it, there could be a run on the dollar. Such weakening could
snowball out of control, especially if smaller central banks
around the world yielded to the temptation to break rank first
and diversify out of the dollar before it lost more of its value.
Bigger players might not be able to stop the destabilization
process once it was set in motion. The financial press is already
awash with stories about central bankers making plans to
diversify reserves in order to reduce their exposure to the dol-
lar and about oil producers parking ever smaller amounts of
proceeds in dollar-denominated accounts. No matter how it
happened, the ultimate effect of a run would be an abrupt rise
in U.S. savings, brought about by sharply curtailed spending
and output, with disastrous effects on the rest of the world as
well. The impact would be similar to that of an abrupt reduc-
tion in the federal deficit.
By now, the first scenario looks increasingly far-fetched, if
not impossible. The housing price bubble is the single most
important obstacle the U.S. economy will face in the next cou-
ple of years. The U.S. personal saving rate is so low mainly
2 Policy Note, 2005 / 3The Levy Economics Institute of Bard College 3
because households are able to tap into the overvalued equity
in their houses by refinancing their mortgages. That, clearly,
will not continue.When housing prices begin falling, the effect
could,potentially,be much worse than the bursting of the stock
market bubble. The impact could be devastating because, cur-
rently,household property holdings are almost twice as large as
the aggregate size of stock portfolios in the United States
(Financial Times 2004). Also, the Federal Reserve will have less
room for monetary easing, and the budget deficit cannot be
increased much more. Moreover, recent news reports about
financial irregularities and undeclared losses at Fannie Mae,
while not surprising, are another sign of serious trouble ahead.
Yet, it appears that just as financial markets are losing all
faith in the viability of this first possibility (i.e., U.S.–led recov-
ery),the pieces are increasingly being held together by the fear of
the second (i.e., complete collapse of the dollar). The latter is
indeed too frightening to contemplate.Hence,the term,“the bal-
ance of assured mutual financial destruction,”coined recently by
Larry Summers, captures the knife-edge quality of the unstable
state of the dollar. The first possibility, as described above, is but
a chimera;the second,a nightmare.That alone,one would think,
makes a third option desirable.What would a third option be?
That option would depend on whether those who are in a
position to make or break the dollar would be able to engage
the United States “constructively,” now that it is no longer in a
position of strength.With the political, economic, and military
strain of Iraq beginning to show, time will tell if the current
U.S. “charm offensive” against Europe is too little, too late.
Many in Europe (and around the world) feel that a “humbled
George W.Bush administration”will be impossible unless neo-
conservatives lose face in Washington, while others will argue
that Europe cannot afford to let a failed United States turn its
back on the rest of the world. However, the economic and
political costs of keeping the United States engaged on its own
terms—with its neoconservative unilateralism intact—will
continue to rise steadily. In the event, the world will prepare
harder for the day when it will have to wean itself from the U.S.
markets.The Asian central banks are unlikely to start selling off
dollars in financial markets any time soon, though their gov-
ernments will probably become increasingly assertive in trying
to use their cache of dollars to acquire control over real
resources around the world. The recent Chinese incursion into
the Canadian oil sector and China’s stepped-up investments
throughout Latin America are cases in point. Judging from the
reaction in the U.S. Congress to the planned purchase of IBM’s
personal computer business by the Chinese-controlled Lenovo
Group, political tensions are sure to rise, perhaps even before
economic complications take center stage, and, as a result, the
dollar might have a respite in the short run. What happens in
the longer term might be more certain.
Disquiet and Division
An extended period, characterized by increasing unease about
the weakening dollar and heightened uncertainty about other
major currencies, is bound to blunt the attractiveness of the
dollar for wealth owners in the rest of the world. Once the dol-
lar ceases to be the magnet it has been until recently, not only
will hot money flow out of the center, but “local” wealth will
return home in the periphery. For developing countries, this
holds the promise of at least a partial respite from their vulner-
ability to international capital markets in the era of globaliza-
tion. If they bear fruit, some of the current attempts at estab-
lishing regional economic and financial networks can help
entrench this relative expansion of “breathing space” in the
developing world. For instance, the growing cooperation with-
in Asean Plus Three (APT),which brings the member countries
of the Association of Southeast Asian Nations together with
China, Japan, and South Korea, can eventually give rise to a
regional financial network. This idea is similar to that of an
Asian Monetary Fund, which the United States and the
International Monetary Fund (IMF) stridently opposed in the
aftermath of the Asian crisis.
It is often remarked that whatever doubts the world might
have about the leadership qualities of the United States—
whether in terms of its ability to act as the economic engine of
world growth or keep to the moral high ground—the world has
no alternative. Lest this give a false sense of stability, however,
the issue might be the dissipation of U.S. power, rather than a
transfer of its power to another entity.A loose alliance of coun-
tries that have come to define their self-interest with the cre-
ation of a multipolar world that bypasses the United States
might be in the making. A recent Central Intelligence Agency
assessment finds that, “An EU [European Union]–China
alliance, though still unlikely, is no longer unthinkable,” and
notes that, because of its growing ties to China, Europe’s 
 allegiance could, eventually, shift away from the transatlantic
alliance (Dombey and Spiegel 2005). That such an assessment
was made is highly significant.Despite strong U.S.opposition,
the EU is setting up a satellite network,called Galileo,that will
break the monopoly of the U.S.global positioning system,and
moving ahead with its own rapid reaction force and military
planning agency independent of NATO. The United States is
even more irritated by the EU’s determination to lift the arms
embargo against the Chinese and by China’s planned involve-
ment in the European satellite network. In 2003 I mused, in
another policy note (Ertürk 2003), about the possible emer-
gence of a formidable Eurasian bloc—bringing together a
viable reserve currency (the euro), a credible capacity for
nuclear deterrence and oil production (Russia), and an eco-
nomic kingmaker (China)—before remarking that it was basi-
cally inconceivable. Today, that proposition, though still far-
fetched, is no longer empty.
References
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Lift its Weapon Ban on China.”Financial Times,
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Financial Times. 2004.“America’s Ominous Housing Bubble,”
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Unthinkable Become Thinkable?”Policy Note 2003/7.
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Papadimitriou, D. B., A. M. Shaikh, C. H. Dos Santos, and 
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2004.“America’s Ominous Housing Bubble,”

Europe is Ready to Lift its Weapon Ban on China.”Financial Times,

Future of the Dollar: Has the Unthinkable Become Thinkable?”Policy Note 2003/7. Annandale-on-Hudson,N.Y.: The Levy Economics Institute.

How Fragile Is the U.S. Economy? Strategic Analysis.

Prospects and Policies for the U.S. Economy: Why Net Exports Must Now Be the Motor for U.S. Growth. Strategic Analysis. Annandale-on-Hudson,N.Y.: The Levy Economics Institute.

"Is the Dollar at Risk?"

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