Benn Steil discusses U.S. fiscal problems and the dollar during the symposium.

Steil was among panelists at the Feb. 21 Keizai Koho Center symposium who spoke on the challenges facing the Bush administration on the economic and trade fronts.

Steil explained how the U.S. fiscal and current account deficits pose a serious risk to global confidence in the dollar.

While the ratio of U.S. budget deficit to GDP was 3.6 percent in 2004, the figure climbs to 5.3 percent if money set aside in trust funds for social security and Medicare is excluded, he said.

Meanwhile, the U.S. current account deficit stood at 5.2 percent of GDP in 2004.

Steil said roughly one-third of the decline in national savings produced by an increase in the budget deficit is financed by capital imported from abroad. And currently, the U.S. needs to import $2 billion of capital each day from abroad.

Many seem to believe a slow, moderate decline in the dollar would bring down the current account deficit, on the grounds that a weaker dollar would cut the trade deficit through market forces, Steil noted.

"But econometrics evidence shows that imports in the U.S. are insensitive to changes in the exchange rate," he said.

While some argue that the trade deficit with China would decline if Beijing revalues its renminbi currency, Steil pointed out, they do not realize that, for example, an increase in prices of socks imported from China will not mean sock factories will emerge in the U.S. American consumers would likely end up paying more for the socks from China, he said.

"So we've got an essential problem here: The U.S. consumes far more than it produces," Steil said.

Asia "produces far more than it consume" and has invested heavily in U.S. debts, he noted. "But can this relationship continue on indefinitely?"

In 1985, the U.S. current account deficit was equivalent to 2.8 percent of GDP, and foreign governments controlled 8.4 percent of U.S. debt. In 2004, with the current account deficit reaching 5.2 percent of GDP, foreign governments control 27.6 percent of the U.S. debt, Steil said.

"In 2003, central banks around the world bought $441 billion -- equivalent to 83 percent of the U.S. current account deficit. Asia alone controls $2 trillion in reserves -- most of them held in dollars," he said.

This represents "a very great concentration in holdings of U.S. debts among a relatively small group of institutions" which, because they are not in the private sector, may decide to buy or sell U.S. debts for "noneconomic reasons," he observed.

Steil cited the lesson of gold as one reason why this situation is alarming.

The price of gold declined from $615 an ounce to $381 during the 1980s, but central banks around the world increased their stocks of gold by 344 tons. Then as the gold price continued to decline, the central banks changed their policy -- selling a net 3,148 tons of gold from their reserves in 1992 alone.

Over the past five years, the dollar -- like gold in the 1980s -- was declining but central banks increased their holdings.

"Today, gold is no longer a significant component of central bank reserves. The dollar has essentially replaced gold as the foundation of the world monetary system," he said.

"This is unique in world history, in that the dollar is completely uncollateralized -- it is backed only by confidence in the performance of the U.S. economy. That puts a tremendous responsibility on the U.S. to behave responsibly with regard to the future of the dollar," he added.

What are the consequences if Washington fails to do so?

"Just as central banks sold gold heavily in the 1990s, they could start selling dollars and increase the proportion of, for example, the euro in the reserves that they hold," he said.

This would mean a global loss of confidence in the dollar, which would be dangerous "because the U.S. dollar is the closest thing we have to an international currency," he warned. The U.S. would lose its influence in global norms of commerce, but the impact would be more far reaching as it would endanger the prospect of international currency consolidation attempts like the "dollarization" movement in Latin America, he added.

To avert this, Steil said, the only lever that the U.S. controls is its budget deficit. However, reducing the budget deficit alone would be insufficient to wipe out the current account deficit because it is estimated that cutting the budget deficit by $100 would result in lowering the current account deficit by only $20, he added.

The Bush administration has stressed that U.S. trading partners like Europe and Japan need to grow more rapidly to resolve this problem. "But the U.S. does not control that lever. If the U.S. wants to send a message to the world that they should have confidence in the future of the dollar, the first thing the administration must do is bring down the budget deficit significantly, and more importantly, to bring down the trajectory of the budget deficit in the future," he noted.

And Japan's foreign currency portfolio, as a result of its massive dollar-buying currency market intervention, has become highly sensitive to the performance of the dollar, he said. It can contribute to rectifying this dangerous international imbalance by doing what it can do push up its own economy, he suggested.

Other panelists spoke on trade issues. Claude Barfield, resident scholar and director of science and technology at the American Enterprise for Public Policy Research, said that while the Bush administration has tended to link security and diplomatic considerations in its trade policy, it has paid insufficient attention to the dramatic changes taking place in East Asia.

As a result, the U.S. is now behind the curve in developments in this region, Barfield told the audience.

The Asia-Pacific Economic Cooperation forum, which used to represent the active U.S. involvement in free trade initiatives in the region, is now moribund, even though on paper it has ambitious trade liberalization commitments by its members, he noted.

One option for the Bush administration, he said, is to revive APEC. Another would be for the U.S. to engage with the ASEAN plus Three grouping, which in many respect has developed into something like a "mini-APEC without the U.S.," he added.

Myron Brilliant, U.S. Chamber of Commerce vice president for Asia, said he does not expect much changes in the administration's trade policy, with its resources largely taken up by Iraq and domestic economic issues like social security reform.

The U.S. will push for successful conclusion of the Doha Round of trade liberalization talks under the World Trade Organization, but it is not clear whether a new U.S. Trade Representative will get sufficient political support from the White House in that respect, he noted.

While Japan and the U.S. have deepened their security ties, they should also work together for international trade liberalization, he said, adding that Washington has often been frustrated that Tokyo is reluctant to forge a common front in ongoing WTO negotiations.