The real risk to the dollar

In American politics, worries about the national debt are often closely followed by worries about the global reputation of the U.S dollar. That's because America's currency enjoys a unique role in the world: Virtually all international trade and financial settlements are done in contracts written in dollars. This gives the U.S. some unique advantages.

But now Democrats are talking about big policy ideas like a Green New Deal and Medicare-for-All, and about using deficits and borrowing to finance much of that agenda. That's making some economists nervous that mounting debt could finally undo the dollar's global privileges: "How much more debt can you have on the U.S. balance sheet and not have global financial markets react? I don’t know the answer to that," Douglas Holtz-Eakin, a conservative economist and a former director of the Congressional Budget Office, told the Wall Street Journal. "I see no reason to run the experiment, 'When do we have a crisis?' Let’s just not."

But how would such a crisis unfold, exactly? And how much debt would it take?

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Let's start by looking at how things work for everyone else. If you're not the U.S., and you want to trade with other countries, you have to deal in dollars. You get paid in dollars for your exports, and you pay in dollars for imports. In fact, your exports are how you get the dollars to pay for your imports. You can create as much of your own national currency as you want, but you can't create more dollars; you have to go get them somehow.

If an economic crisis wrecks your exports, you can run out of dollars. If you borrow dollars, then you're saddled with debt in a currency you don't control. If you run out of dollars, you can't import more, you default on your dollar-denominated debt, and your economy plunges into crisis. That's what what happened in Venezuela and Turkey, to take two recent examples.

Thanks to the unique global role of the U.S. dollar, America is free from this entire doom loop. All the international trading we do is in dollars, and we print all those dollars. We've run persistent trade deficits for a while now — importing more than we export — but we don't have to go out and get the currency to buy those imports from anywhere.

Now, what does our debt load have to do with all this?

If you need dollars for international trade, but you can't create more of them, you'll want a rainy day fund to protect yourself in a crisis. As a result, about two-thirds of all foreign currency reserves around the globe are in U.S. dollars. Practically speaking, the way countries get dollar reserves is by investing in dollar-denominated financial assets. Mostly that means investing in U.S. Treasury bonds. And U.S Treasuries get created whenever America deficit spends and borrows.

The worry among economists like Holtz-Eakin is that if the U.S. government issues enough Treasuries, it will completely saturate global demand. At some point, the theory goes, the rest of the world will just say thanks, we have enough Treasuries and stop buying. Then it would fall to the Federal Reserve to soak up the excess supply.

The problem with that isn't that the debt could ever get "too big." Any central bank can create limitless demand for the bonds the country's government issues in its own currency. But if deficit spending is too big at the wrong time — if it hits when the economy is already booming and near full capacity — then the economy can't absorb the new spending without prices going up. At that point, higher interest rates are the only thing that will hold inflation in check. But if the Fed is buying up all those new Treasuries, then by definition it's keeping its interest rate target down.

A big bout of inflation in the U.S. dollar is ultimately what would destroy the currency's unique role in global trade. If the inflation was bad enough and lasted long enough, it would make it impractical for other foreign producers to keep doing international trades in dollars. Dollars w would be too cheap relative to other currencies, and they'd lose too much money. Eventually, they'd ditch the dollar for some other currency. And then America would be in the same boat as the rest of the world.

But how likely are we to set off that kind of inflation crisis?

It's not just the timing of deficits that matters; it's the nature of the deficits. Trump's tax cuts, for instance, created huge new deficits, but haven't proven inflationary at all. To overheat the economy, your deficits have to create so much new consumer spending that the supply of workers and real resources can't keep up with aggregate demand. Trump's tax cuts just gave money away to rich people.

A Green New Deal and a job guarantee and Medicare-for-All would certainly create way more demand than Trump's tax cuts. But even here, the picture is complicated. A job guarantee is designed to push the economy to full employment, but not beyond. A lot of Medicare-for-All's spending wouldn't be inflationary because it simply replaces private sector spending. And a Green New Deal is supposed to be a temporary policy, that gets rid of demand for fossil fuels even as it ramps up demand for renewables.

In truth, creating too much inflation by overheating your economy is just really hard to do. The closest we came was probably World War II, when deficits hit 25 percent of GDP, and the Fed avoided interest rate hikes to support the war effort. Even then, inflation didn't get much above 10 percent, because the government managed prices in other ways. These days, the Fed absolutely would raise interest rates if the Democrats deficit spent on the new progressive agenda. Ten percent inflation for a while is probably close to a worst-case scenario.

Would that be enough to drive foreign exporters off the dollar? Ultimately, there's no way to know. Holtz-Eakin is right insofar as there is a risk. The question is whether it's riskier than a country without universal health care and a green economy.