Reckless Spending Threatens America's Place at the Top

The house of cards that Democrats have been building over the past two years is teetering precariously. Namely, we have misused our status as the world’s global reserve currency of choice.

Over the past year the Democrats have spearheaded a fiscal effort to jumpstart the economy. The centerpiece of this approach was the $862 billion stimulus bill that was supposed to pump money into the hands of consumers and jumpstart our economic recovery. Except that none of that happened. Instead we were left with historic debt and deficits and an economy that was still sluggish at best.

Despite the lackluster performance of the package, many liberal economists, most visibly Paul Krugman, argued that the President needed to pass another stimulus plan. As he wrote in yesterday’s New York Times, “Mr. Obama’s problem wasn’t a lack of focus [on the economy]; it was a lack of audacity. At the start of his administration he settled for an economic plan that was far too weak.”

These economists argued that austerity was foolish at a time like this. “Right now, investors don’t seem at all worried about the solvency of the U.S. government; the interest rates on federal bonds are near historic lows.

In other words, why should we cut back on government spending if we can continue to borrow money at really low rates? If other nations are willing to fund our extravagance why hold back?

The latest slap in the face to foreign investors is a new round of “quantitative easing.” This is a plan implemented by the Federal Reserve in which they purchase 5-to-10 year Treasury securities in the hopes that it will increase the price of bonds and thus reduce interest rates. The hope is that the lower interest rates will increase liquidity and make corporate financing cheaper.

But as Duke professor and National Bureau of Economic Research associate Campbell Harvey explains,

There is a secondary effect. As U.S. interest rates go down, the U.S. is presumably less attractive for foreign fixed-income investors. This may put downward pressure on the exchange rate. A cheaper exchange rate means exports are more competitive and imports are more expensive.

The combination of these two policy trajectories – fiscal and monetary – is beginning to leave a bad taste in the mouths of some foreign governments. Some are openly resenting the dollar’s preeminent status as the de facto world currency. In their view, such “dollar hegemony” was a “major cause of both the imbalances and the crisis, for it allowed more or less unbounded borrowing by the US from the rest of the world, at very favourable rates.”

The dollar has been the world’s reserve currency since World War II. With many of the world’s financial systems in shambles the Allied nations gathered in Bretton Woods to set up a new system of rules to manage the new international monetary system. One of the primary results of the meeting was an obligation that every nation adopt an exchange rate that stayed within a fixed value. This combined with the newly established ‘gold standard” persuaded other nation to peg their currencies to the price of the U.S. dollar.

For seven decades this system worked fine because the US was the dominant economy, had a sterling credit rating, and was a very stable monetary system. Now some are wondering if that reality holds true. As Jeremy Warner wrote in the UK Telegraph,

America has squandered this advantage on credit-fuelled spending; with the developing world expected to represent more than half of the global economy within five years, dollar hegemony no longer makes any sense.

Warner senses that the United States is leveraging its role as the global currency to address its domestic needs, the rest of the world be damned. And frankly, if you agree with Paul Krugman’s assessment – that we should lap up cheap debt so long as the world is giving it to us – then Warner is exactly right.

Our fiscal impropriety will not last forever. We are still the world’s dominant economy.  But we must not let our hubris blind us from the harsh reality – that our reckless spending has compromised our place at the top.

by Brandon Greife, Political Director of the College Republican National Committee