Warnock argues that the respite from financial calamity must be used to get the United States financial house order. Good luck with that.
Here is the introduction from this very important paper:
Keep in mind this is a CFR publication so there is no recognition that gold is a better reserve currency than the dollar, or any other currency, and keep in mind that because this is the CFR there is the obligatory note that a strong dollar allows for the U.S."to conduct an assertive foreign policy precisely at moments when crises demanded it."
In 1961, the Belgian economist Robert Triffin described the dilemma faced by the country at the center of the international monetary system.
To supply the world’s risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened. The endgame to Triffin’s paradox is a global, wholesale dumping of the center country’s securities. No one knows in advance when the tipping point will be reached, but the damage brought about by higher interest rates and slower economic growth will be readily apparent afterward.
For a long time now, the United States has seemed vulnerable to the fate that Triffin predicted. Since 1982 it has run a current account deficit every year but one, steadily piling up obligations to foreigners. Because foreigners have been eager to hold dollar assets, they have willingly enabled this pattern, pouring capital into the United States and financing the nation’s surplus of spending over savings.
The dollar’s status as the world’s reserve currency has become a facet of U.S. power, allowing the United States to borrow effortlessly and sustain large debt-financed military commitments. Capital has tended to flood into the United States especially readily during moments of geopolitical stress, ensuring that the nation has had the financial wherewithal to conduct an assertive foreign policy precisely at moments when crises demanded it. But the capital inflows associated with the dollar’s reserve-currency status have created a vulnerability, too, opening the door to a foreign sell-off of U.S. securities that could drive up U.S. interest rates and render the nation’s formidable stock of debt far more expensive to service.
Late last year, this potential danger came close to becoming reality. Largely thanks to homegrown pressures, unrelated to Triffin’s dilemma, the world’s risk-free asset, the ten-year U.S. Treasury bond, was sagging.
With sizeable budget deficits, the prospects of an ever-increasing amount of government debt, the end of the Federal Reserve’s crisis-driven program of accumulating Treasury bonds, and an uptick in inflation expectations, the ten-year Treasury yield increased by fifty basis points from 3.25 percent to 3.75 percent. And further increases were likely. Such increases would not only substantially raise the cost of future government borrowing, but would also threaten any recovery in housing and other interest-rate-sensitive sectors.
At the same time, moreover, foreigners seemed poised to drive U.S. borrowing costs higher. The dollar was falling sharply. Early in 2009 it fetched almost eighty euro cents in Frankfurt or Athens; by autumn it was worth sixty-seven euro cents. Foreign investors, who held more than half of the U.S. Treasury market, were getting nervous. Luo Ping, a director-general at the China Banking Regulatory Commission, summed up the angst:
Except for U.S. Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option . . . . We know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.2
Was Triffin’s endgame—sudden reserve diversification, or the act of foreign governments abruptly shifting their funds from dollars to other currencies—about to become a reality? If so, the likeliest benefactor was the eurozone. Prominent economists opined that the euro would become the world’s reserve currency by as early as 2015.3 Through the first half of 2009 global investors seemed to agree: net inflows into eurozone debt instruments—that is, the rest of the world’s purchases of eurozone bonds less euro-area purchases of foreign bonds—surged to record levels. The related plummeting of the dollar relative to the euro added to the fear that global investors were abandoning the center country.
But then began the eurozone phase of the global financial crisis. This has provided the U.S. government with a timely respite from both domestic forces and Triffin’s endgame. U.S. policymakers need to understand that this is not a reset, not a new beginning; it is a lucky break. How the United States uses this reprieve will affect the nation’s ability to borrow for years to come, with broad implications for the sustainability of an active U.S. foreign policy...
Aside from these points, this is the most important paper I have seen come out of the establishment in some time. That said, Warnock does not discuss how this "period of respite" should be used to bring about a decrease in government debt. The correct answer is, of course, to cut government spending and allow the funds to be used by the private sector. However, Warnock's warning could be, unfortunately, used by interventionists to call for higher taxes, which, of course, would suffocate the private sector.
Read the full paper here (Pdf).