Central banks accumulating U.S. dollars are taking on ever-greater currency risk. If the dollar were to depreciate, their losses would be large. Thus, they have an incentive to diversify their holdings rather than relying so heavily on dollar-denominated assets. But this could itself cause the dollar depreciation they fear.
This situation is a risk to the United States as well. While there has been no hint, as yet, that nations with large dollar reserves would use such holdings for economic or political leverage, that is a possibility.
Time For Action The greater fear has as much to do with mathematics as it does with economics. Even gradually increasing trade deficits can lead to accelerating current account deficits. Today’s borrowing abroad means a further outflow of income (the interest on that borrowing) tomorrow, over and above the trade deficit itself. In the extreme, such a “debt trap” very quickly spirals out of control, producing the dreaded hard landing—at a minimum, economic recession coupled with sharply higher interest rates, rising bankruptcies, and flat or even declining house prices.
The “soft landing” is no picnic either. It means some combination of greater personal savings (lower personal consumption), higher taxes, lower government spending, lower investment and a still-weaker dollar. And you can count on considerably higher interest rates as one of the principal means of achieving such ends.
Such a scenario may seem remote. And it may be, at present. But the longer we wait to resolve the problem, the more likely such outcomes become.
To be sure, faster economic growth in Europe (and elsewhere) would help, as would revaluing the Chinese currency upward. Still, it is hard to construct an end game that doesn’t involve sacrifice on the American home front.