How US Debt Risks Dollar Doomsday

The US dollar is getting perilously close to losing its status as the world’s reserve currency. Should it cross the line, the 2008 financial crisis could look like a summer storm.

Yes, worries about insolvency in Europe dominate the headlines. Last week, Standard & Poor’s cut Spain’s bond rating to BBB+ — a clear sign that Europe’s financial crisis is far from over.

But America’s escalating debt problem is far more likely to precipitate a truly global crisis, because the dollar has for decades played such a central role in the world economy.

How bad is the US problem? Former Treasury official Lawrence Goodman recently pointed out that investors are shunning US bonds and notes; the lack of other buyers forced the Federal Reserve to buy “a stunning . . . 61 percent of the total net issuance of US government debt” last year. Like many others, he warns that ballooning debt puts the US economy at risk for a sharp correction.

But the even larger risk is the potential loss of the dollar’s “reserve currency” status — a key support of the world economy for the last four decades.

It started with the 1973 Saudi commitment to accept only US dollars as payment for oil, followed by OPEC’s 1975 agreement to trade only in dollars. Trading of other commodities came to be priced in dollars, reinforcing the dollar’s “reserve” status.

As a result, central banks worldwide have held onto large reserves of dollars to facilitate trade. That, in turn, has enabled the US to print much larger amounts of its currency, with seemingly little inflationary consequences. It’s also made it easier for Americans to import more than they export, to consume more than they produce, and to spend more than they earn.

But all that is changing rapidly.

A number of countries are abandoning the dollar for the Chinese yuan. Last December, Japan and China agreed to trade in yen and yuan. In January, the 10 nations of the Association of Southeast Asian Nations finalized a non-dollar credit agreement equivalent to $240 billion, strengthening their economies’ links with China, Japan and South Korea.

That same month, Chinese Premier Wen Jiabao signed a currency-swap agreement with the United Arab Emirates, which holds 7 percent of the world’s oil reserves. Iran has agreed to accept rubles and yuan in trade with Russia and China, and now is trading oil with India in rupees and gold.

In late March, the China Development Bank agreed with its counterparts in Brazil, Russia, India and South Africa to eschew dollar lending and extend credit to each other in their own respective currencies.

With global demand for dollars falling, central banks around the world will inevitably reduce their dollar reserves. That selloff further weakens the dollar against other currencies and in turn drives up inflation.

All this comes as US federal debt is soaring, adding to concerns about the future value of that debt and of the dollar. It’s suddenly much easier to imagine a dollar collapse — which would be a highly unexpected occurrence, known as a “black swan” event. This would precipitate unprecedented disruption, because the dollar remains the world’s most important currency.

Let’s hope we can avert a global crisis triggered by reckless US government spending. What’s needed is new leadership in Washington with the courage to get our fiscal house in order and to defend the dollar against attack in a competitive global market.

Scott S. Powell is a senior fellow at the Discovery Institute in Seattle.