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Published: March 1, 2005

 
 

Are Dollar Reserves Still Safe?

  • Accelerate rapid growth in the economies of U.S. trading partners.
  • Have a severe economic downturn in the United States.
  • Experience a sharp decline in the value of the dollar.

Although more rapid growth worldwide would be desirable, there is little reason to expect a major upturn in the near future, and no credible forecasters are predicting sustained high growth. But there are factors that could lead to a sharp downturn in the U.S. economy, most obviously a collapse of an overheating construction and real estate market. Still, the Federal Reserve Board and the Bush administration are not likely to accept a prolonged downturn. They would take aggressive action to provide an economic stimulus if conditions sour.

This leaves a sharp drop in the dollar as the only plausible correction mechanism for the current account deficit. In the third quarter of 2004, we calculated that a drop in the value of the dollar of approximately 22 percent would be needed to bring the U.S. current account deficit down to a sustainable level, or approximately 3.0 percent of GDP. The longer the decline is delayed, the more dollar depreciation will be needed to reduce the current account deficit. As of December 2004, the deficit was already $100 billion higher than the figures we used when we ran the above calculation.

A drop in the dollar of 22 percent would mean big losses for countries with large dollar holdings. For example, a country holding reserves equal to 10 percent of GDP would lose 2.2 percent of its GDP; this is more than 10 percent of the annual budgets of most developing countries. A hit this large could force a substantial economic contraction in most developing countries and could diminish the purchasing power of consumers who drive growth in these countries, and who are a new target market for multinational companies.

This simple arithmetic should demonstrate the urgent need for governments to diversify their reserve holdings away from dollars. As Alan Greenspan said in a slightly different context, anyone holding large numbers of dollars at this point “must be desirous of losing money.” 

Author Profiles:


Dean Baker ([email protected]) cofounded the Washington-based Center for Economic and Policy Research. Dr. Baker is the coauthor of Social Security: The Phony Crisis (University of Chicago Press, 2000) and editor of Getting Prices Right: The Debate Over the Consumer Price Index (M.E. Sharpe Press, 1997), which won a Choice Book Award.

Mark Weisbrot ([email protected]) cofounded the Center for Economic and Policy Research with Dr. Baker. He is the coauthor of Social Security: The Phony Crisis.
 
 
 
 
 
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