Persistent inflation will lead to rate hikes-that instability sparks a dollar crisis

Current inflationary problems are not “transitory” but seem more likely to be sustained by a long list of overlapping and negative supply side shocks: prepandemic resource misallocations of capital driven by easy money, post-pandemic “hysteresis” affecting both capital and labor, population aging, climate change and the heavy costs of both adaptation and mitigation, commodity price increases, and finally deglobalization. Persistently high inflation could eventually lead to higher real interest rates that would reveal all of the underlying fragilities that have built up over the years.

Nor are we well-placed to manage another global crisis. Political problems are lurking under the surface almost everywhere, not least because of rising inequality, and these will be aggravated by either rising inflation or rising unemployment which disproportionally affect the poor. Moreover, our crisis management tools are heavily constrained or otherwise inadequate. Finally, needed debt restructuring will be constrained by inadequate laws and administrative procedures. Indeed, at the international level, we even lack basic principles to guide sovereign debt restructuring.

Why might another deep economic and financial crisis spark a dollar crisis when previous crises have not done so? The first argument is that the many reasons for expecting a sharply weaker dollar are still valid. The Triffin dilemma grows more acute with time. The U.S. current account has been in deficit for decades and it has recently expanded sharply as a percentage of GDP. Similarly, the net U.S. international investment position has been worsening almost exponentially. It is also notable that cyclical lows in the effective value of the dollar (1971, 1985, and 2001) have been successively lower and that the current effective level of the dollar is at a record high relative to that trend.

A second argument is that important governments might lose their appetite for policies that support the current system. In a new crisis, instability in the U.S. marketbased financial system could easily lead to a sharper economic downturn than elsewhere. Moreover, history indicates that the U.S. government and the Fed would attempt more radical forms of macroeconomic easing than others, letting the dollar adjust as needs be.