Return of the Twin Deficits: Consequences for the Dollar and the Economy

Abstract

Does America’s return to “twin deficits” imply an unstable dollar or a return to the “declinism” of the 1980s? Ending the Cold War and establishing the Euro did leave the dollar in a fundamentally weaker position. The Clinton administration, however, eliminated the fiscal deficit. And although the large external deficit continued to increase, it was financed to a great extent by foreign direct investment that strengthened the real economy. Since the dot.com crash, however, the dollar has depended on more official and less stable forms of support – mostly portfolio investments from Japanese and Chinese central banks. In the longer term, given the difficulties of adjusting Western living standards to Asian competition, a global system of floating currency blocs seems probable. The U.S. is unlikely to maintain its dominant position by converting the “war on terror” into a geopolitical alliance comparable to the Cold War.