Wharton 9

As the global economy appears headed toward recovery, concerns are growing that the United States' addiction to massive fiscal stimulus as an economic panacea could eventually lead to an even bigger crisis -- a loss of confidence in the U.S. dollar. Prominent voices are sounding dire warnings, worried that a gradual return to normalcy could undermine the political will needed to control deficit spending and prevent a disastrous long-term decline of the world's primary reserve currency. Nobel Prize-winning economist Paul A. Samuelson, for example, raised the specter of a "truly global financial panic" if countries funding the U.S. deficit, particularly China, decide their investments in U.S. Treasury securities are no longer safe. Similarly, Warren Buffett warned in The New York Times that side-effects of the current fiscal intervention could be as dangerous as the financial crisis recently averted -- in the form of inflation eroding the dollar's purchasing power. Preserving the dollar's strength has importance far beyond protecting American tourists from the shock of paying the equivalent of $25 for a hamburger in London or Tokyo. The U.S. dollar exchange rate is a key indicator of the nation's economic health relative to other countries. A declining dollar leaves Americans worse off by driving up the cost of living, making imports of manufactured goods and commodities more expensive, and reducing the value of foreign investments when converted to dollars. Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term. The U.S. imports far more goods and services than it exports, flooding international markets with dollars and undermining their value. The current account deficit -- the net balance of trade in goods, services, income and transfers -- was $700 billion in 2008. The U.S. trade deficit remains by far the world's largest, although it declined 35% in the first quarter of 2009 as the recession dramatically reduced demand for oil and other imports. "I see the potential for the dollar to deteriorate quite substantially in the long run," says Wharton finance professor Richard C. Marston, unless Congress and the Obama administration quickly reduce spending as the economy recovers. "If we continue to borrow from foreign countries to sustain our spending, eventually there will come a time when asset holders around the world will begin to wonder whether the U.S. is credit worthy," adds Marston, director of the Weiss Center for International Financial Research. Reflecting the size of the fiscal stimulus, the federal budget deficit is projected to be $1.6 trillion in 2009 -- the highest level since World War II -- amounting to 11% of gross domestic product (GDP), a dramatic increase from 3% in 2008. To fund its deficit spending, the U.S. depends on the willingness of major trading partners, such as China, Japan and Korea, to purchase and hold Treasury securities paying low interest rates. China has recently voiced serious concern about the potential inflationary impact of the U.S. fiscal stimulus on the value of China's $1.5 trillion in U.S. government securities and other dollar-denominated reserves.