Beg, Borrow, Zeal: Gorging on America’s <em>Liquid</em> Diet

While you were eating turkey and trying to find a parking place at the mall late last week, those supposedly feckless Europeans were actually pretty hard at work. Of course, they had to be — the alternative was to see their financial system collapse. Here’s what they were up to:

• Working over the weekend, Ireland, the European Central Bank and the IMF worked out an 85 billion euro ($113 billion) rescue package for the debt-hobbled Emerald Isle. As a condition for getting bailed out, Ireland announced it would give 25,000 government workers the ax and add 5 billion euros (about $6.5 billion) in new taxes. On Saturday, 50,000 marched through Dublin to protest the impact this would have on Ireland’s economic growth. Read one protester’s sign: “No Country for Young Men.”
• On Friday, Portugal passed its own draconian budget, instituting the steepest cuts in three decades. The sacrifices might (but probably won't) head off the need for that nation, too, to seek help from deeper pockets in Europe. Never mind that two days earlier, a massive protest strike paralyzed transportation and government services.
• On Friday, Spanish Prime Minister Juan Luis Rodriguez Zapatero challenged currency traders to make his day, in the Ronald Reagan sense: “I should warn those investors who are short-selling Spain that they are going to be wrong,” he promised — before later outlining his own package of government spending cuts. Voters in the northeastern state of Catalonia responded days later by running his fellow Socialist party incumbents out of office in local parliamentary elections.

What’s the American reaction to all this? For starters, we probably should race back to our Thanksgiving Day gratitude journals and make one more entry: Thank goodness the dollar is the world’s top reserve currency. But for the greenback’s special status, the U.S. economy could well face a Thanksgiving Day fiscal massacre, just like Ireland, Portugal and Spain. It certainly isn’t because our government or bankers are so much more responsible.

What's so great about the dollar? Most important, it's the world's main reserve currency. This simply means that the dollar is the currency foreign central banks most like to keep on hand to settle international debts. (Precisely speaking, the dollar makes up about two-thirds of the world’s reserves.) That creates a deep, liquid market for the greenback, which helps make it the favored yardstick for pricing goods from oil to gold to computers. That, in turn, helps create a more or less permanent demand for U.S. government debt, the main instrument for acquiring dollars.

The practical effect is that Uncle Sam can borrow cheap — while the Irish and Portuguese can’t. We can lavish government benefits on seniors, the military and other favored groups without raising taxes, confident that the world will lend us the difference. Like the hairdressers who borrowed to buy mansions during the housing boom, our access to credit is increasingly divorced from the reality of our financial picture. And in tough times like now, we have the uniquely extravagant privilege of being able to pay our creditors in currency that we can print at will. As Daniel Gros, director of the Center for European Policy Studies puts it, “The U.S. seems to have come as close as one can imagine to getting the proverbial free lunch.”

So far, at least, the rest of the world is strangely okay with that. The dollar’s special status is partly protected by what economists call network externalities: For obvious reasons, it’s more efficient to own the currency that everyone else trades in, even if you don’t like the people in charge of it. It also helps that there is, as yet, no viable alternative to the buck. The euro, the number two reserve currency, is struggling with its own built-in contradiction — mainly that it’s the national currency of both the prosperous, frugal Germans and the broke, spendthrift Greeks. And the Chinese renminbi, still subject to export controls and slavishly pegged to the value of the dollar, is not ready for prime time.

Not yet, anyway. The financial crisis has damaged confidence in the U.S., and decades of headlong borrowing have shifted economic power from us to our creditors. University of California, Berkeley, economist Barry Eichengreen, among many others, thinks it’s inevitable that the dollar will cease to be the only game in town. “The world economy of the 21st century is becoming more multipolar,” he says. “There is no reason why the same should not be true of its international monetary system.” It’s in no one’s interest for this to happen abruptly. But within 10 years, Eicengreen envisions the euro and the renminbi sharing center stage with the buck. One baby step in that direction took place over Thanksgiving: The Chinese and Russians quietly agreed to settle their trades in each other’s currency, leaving dollars out of the equation. “This is the first step in what for China will be an ongoing process,” says Eichengreen.

As Gros points out, the dollar’s special power was never a free lunch anyway. Yes, it let us gorge ourselves on cheap debt and cheap imports, but at the cost of handing economic power to creditors and gutting our manufacturing industry. If the dollar eventually becomes just one of several currencies, we might have to pay for our deficits and bank crises the same way the Irish (and Greek, Portuguese and Spanish) do: By cutting our spending and raising our taxes. It won’t be fun. But it won't be up to us.