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The race for the White House 2012: Losing faith in the dollar?

The biggest challenge facing the US is the growing size of its public debt, says Professor Michael Ben-Gad.
by Ben Sawtell

At the moment the US government borrows just over one third of what it spends. Because US savings rates have traditionally been low, in the past much of the debt was purchased by foreigners, particularly the Chinese and Gulf Arabs. Now they and the other emerging powers' central banks are buying gold so instead two-thirds of the deficit is being financed by Fed purchases, in other words the printing of money.

The balance sheet of the Fed has tripled in size in the last four years. Only the willingness of banks and the corporate sector to sit on vast mountains of cash, and the fact that the dollar remains the world's reserve currency is preventing inflation.

All of this is happening just before the enormous costs associated with the retirement of the baby boom generation needs to be financed. The US government has been generating enormous unfunded liabilities to this generation and the bill is about to come due.

At some point the rest of the world could lose faith in the US dollar or come to believe, perhaps correctly that with its greatly expanded balance sheet the Fed means to monetise the outstanding debt.

There is the likelihood of a serious sovereign debt crisis or a collapse in the value of the dollar in the next few years. Even with the best will in the world, it is doubtful that there are enough savings in the world to keep feeding both the Federal deficit and the US current account deficit. And all of this is before we consider what might happen if because of a dispute over Taiwan, of the South China Sea, the Chinese decide for strategic rather than merely economic reasons, to begin dumping their dollar denominated assets.

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City, University of London is an independent member institution of the University of London. Established by Royal Charter in 1836, the University of London consists of 18 independent member institutions with outstanding global reputations and several prestigious central academic bodies and activities.