Deficits, Debt and Dollar Demise?

The Heritage Foundation

As unemployment and debt both spiral up, the US economy should brace itself to avoid what could be a real knockout punch. Even before the financial market collapse a year ago, several key countries have voiced their growing concern over the role of the US dollar as the reserve currency in world trade, and many have suggested a new world currency take its place. The world mandate to Obama and Congress is that they are spending too much money and the rest of the world does not want to be stuck with the bill. It’s time for our government to start listening to these serious and dire rumblings.

China, India, Russia and France have all expressed concern that a growing US deficit and debt have the potential to make their $6.5 Trillion in currency reserves worthless.China holds the most US debt including over $800 Billion in Treasury bonds. And while our Treasury Secretary Timothy Geithner makes the case for the need of a “strong dollar”, one must wonder how the world views his words with the US deficit approaching $2 trillion.

The UN has repeatedly called for a new reserve currency again and again. UN undersecretary-general for economic and social affairs, Sha Zukang stating on Tuesday that

“Important progress in managing imbalances can be made by reducing the reserve currency country’s ‘privilege’ to run external deficits in order to provide international liquidity.”

Translation: The world is tired of paying our bills and is willing to dethrone the “almighty dollar”.

The dollar has served as the world’s reserve currency since the Bretton Woods Agreements in 1944. These agreements established that foreign countries were to redeem their currencies into dollars, then be able to convert their dollars into gold held by the Federal Reserve. This system fell apart over the next thirty years due to a negative US trade balance and high inflation brought about by a vast increase in the money supply. Then in 1971 president Nixon officially “closed the gold window”, stating the US would no longer redeem dollars into gold, and the world went officially on a complete fiat money system.

The move by Nixon signaled to the world that the US had no intention (and no ability) to pay back foreign gold redemptions and the move to a total Dollar reserve allowed the US to run even higher trade deficits than before. The world, having used the dollar as a semi-reserve over the previous 28 years, had little choice but to accept the new system which provided considerable benefits, especially from 1980 through 2000.

Now, though, with US running trillion dollar deficits and calls for the debt ceiling to be raised above $12 trillion, the rest of the world has had enough. While the prospect of a currency move does not look imminent and China continues to support the dollar-as pointed out by Heritage research fellow Derek Scissors yesterday-, if the rest of the world does decide to officially drop the dollar quickly, our economy would suffer on a scale that would make the Great Depression look like a picnic.

The solution is clear: Washington must stop spending immediately. The questions facing Congress about which new programs to fund should be replaced with which programs need to be cut. The party is over for the US and the rest of the world has proclaimed they have no desire to clean up our mess. President Obama and the Congress must recognize the disastrous long-term implications of their course, including the world’s eventual reaction, and head us away from the iceberg rather than toward it.

For more information on the current US budget crisis, these Heritage reports lay out what’s ahead for the country.