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The dollar standard allows the U.S. to default on its debt

November 23, 2004

Whenever a country which has had large current account deficits for a long time suffers a fall in the value of its currency in response to this imbalance, huge losses are incurred either for the creditor nation or the debtor nation. Usually it is the debtor nation which suffers as the fall in the value of their currency increases the debt burden nominated in the foreign currency. This was for example the case in East Asia when the most heavily indebted nations suffered sharp economic downturns after their currencies were devalued partly as a result of this massive increase in the debt burden.

But the situation for the United States is much more beneficial because of the dollar's value as the world's reserve currency. Because of this almost all of the foreign debt is nominated in dollars. That in turn means that the U.S. won't see its debt burden increase when the dollar falls. Instead it will be the creditor nations which will lose out on the dollar fall.

Today's Buttonwood column in The Economist points out that Japan, China and the rest of Asia has over $2 trillion in foreign exchange reserves, most of it in dollars. A 10% decline in the dollar means that the central banks alone will lose $200 billion. In Singapore, a 10% increase in the value of the Singapore dollar would mean capital losses of 10% of GDP for the central bank alone. Add to that the losses made by private investors.

The dilemma for the Asians is that they must now choose between either taking these huge losses now (To which the losses suffered by their export industries must be added) or further increasing their exposure to the inevitable dollar decline. The United States might not formally default on its debt, but for the rest of the world the falling dollar produces a similar effect as their U.S. assets loses more and more of its value.

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