This piece was originally published in American Compass's Rebuilding American Capitalism.
With the demise of the Bretton Woods system in 1971, countries around the world began to open their markets to foreign investment, and the U.S. dollar emerged as the reserve currency of choice. Today, two-thirds of all foreign reserves and nearly 90% of foreign exchange trades are denominated in U.S. dollars—a phenomenon known as “dollarization.”
As the monetary safe haven to the world, the U.S. current account (or “trade balance”) has been in deficit ever since, growing to a record average of $247 billion in each quarter of 2022. A current account deficit means that the United States is a net borrower, absorbing more in foreign savings than we invest abroad. Those savings are largely held in the form of U.S. government debt, suppressing our borrowing costs and allowing Congress to run large budget deficits with impunity. This is often referred to as America’s “exorbitant privilege,” as the global role of the dollar allows the American economy to consume more than it produces—an apparent “free lunch.”
Yet America’s exorbitant privilege is also an exorbitant burden. Soft budget constraints have atrophied Congress’s ability to make hard trade-offs, shielding new spending from the democratic scrutiny that would occur if new taxes had to be raised in equal proportion. And while economic dogma says current account deficits must eventually be balanced by matching surpluses and, therefore, don’t matter in the long run, it does not say how many decades or even centuries in the future the “long run” might be. In the meantime, large trade deficits have hollowed out America’s productive capacity. Instead of factories and equipment, global savings have flowed into financial products and real estate as quasi-safe stores of value, leading to periodic bubbles. When the U.S. government does the borrowing, the proceeds are sent back out as transfer payments through underfunded entitlement programs rather than leading to any investment at all.