FA: The Dollar and the Deficits (C.Fred Bergsten)

Oh Foreign Affairs (FA). Such long, esoteric articles are difficult to understand in their entirety, but I find it to be a good source of expert opinion on a variety of topics dealing with world affairs.

Most Americans attribute a strong dollar to the strong economic position of the US in the world. A strong dollar allows Americans to live well beyond their means in a culture centered around materialistic desires and the relatively easy fulfillment of those desires. Bergsten seems to accept that this will all change and that, in fact, it is necessary change for the future sustainability of the US (and world) economy. He argues that a strong dollar and current account deficit are harmful for the US 1) because they lead to asset bubbles 2) because at any point foreign investors can refuse to finance the deficit, resulting in "driv[ing] the dollar down, push[ing] inflation and interest rates up, and perhaps bring[ing] on a hard landing for the US--and the world economy at large."

Bergsten's argument against a strong dollar and current account deficits can be outlined in the diagram below ( --> symbol means 'results in'):

Strong Dollar --> trade/current account deficit (i.e. US=world's biggest debtor, China=world's biggest creditor) --> inflows of foreign captial (notably from China) --> low interest rates in US, excessive liquidity, overleveraging and underpicing of risk, loose monetary policy --> asset bubbles and financial crisis (e.g. sub-prime housing bubble and financial crisis of 2007) --> weakening of US/world economy

Bergsten's proposes a few measures to prevent future financial crises like the one we just experienced in 2007. His solutions focus on slowly devaluing the dollar and limiting the current account deficit to avoid another large financial crash in the future:

1) Avoid large external deficits--Bergsten's institution, The Peterson Institute fr International Economics, projects that the current account deficit will rise from 6% of the GDP currently to over 15% of the GDP by 2030. He argues such high levels of foreign borrowing could lead to either another financial crisis or a precipitous depreciation of the dollar when foreign investors refuse fund US debt. He states that a healthy current account deficit level should be no greater than 3% of the GDP.

2) Adapt to a global currency system less centered on the dollar--in order to prevent prodigious amounts of foreign borrowing that leads to the large US external deficit, the dollar needs to be downsized. This will involve a change to the current international monetary policy to "a multiple-currency system in which other monies increasingly share the international position of the dollar in private markets. Bergsten argues against those who view a multiple currency model as unstable that such a system functioned smoothly for several decades before WWI. "The United States should not only accept a more varied currency regime as an inevitable reality but actively encourage such a development as part of its effort to recalibrate its own international economic position."

3) Balance the internal budget--high budget deficits promote trade/current account deficits by pushing up domestic demand that exceeds domestic output, which is remedied by the importing of foreign goods and services. Additionally, high budget deficits encourage the inflow of foreign capital that finances the deficit that cannot be funded by domestic saving. According to Bergsten, balancing the budget requires Americans to save more (a truly difficult task) and to increase taxes on consumption. The big government programs that are in existence will need to undergo cost reductions specifically medicare and social security.

My questions from this article:

1. How is the budget deficit funded domestically vs. internationally? Is it funded both ways? How exactly does the funding of US debt work?
2. Where does budget deficit come from? Government programs?
3. What form does foreign borrowing take? Bond buying? What is a treasury bond? Who can buy them?
4. Why does private saving help reduce budget deficit?
5. How does China play into our current account deficit and the value of the dollar? Why is the undervaluing of renminbi a problem for the US?

The Dollar and the Deficits