The Dollar and Development

Global poverty and poverty reduction are right now, more prominent public issues in high-income countries than they have ever have been, but progress toward the eradication of global poverty is at increasingly grave risk due to global macro-economic imbalances. At the heart of the problem is the U.S. external deficit that has turned the U.S. into the world’s largest debtor nation while developing countries, most notably in East Asia, are now among the world’s largest creditors. The impact of the adjustment of the U.S. external deficit on developing country economies will depend on U.S. macro-economic policy ahead, whether growth of U.S. exports or a decline in U.S. imports accounts for most of the reduction of the external deficit, how China, and by implication the rest of East Asia, respond to what happens in the U.S., and on the speed with which the U.S. deficit is closed. A review of how the world economy came to find itself in this historically unprecedented situation is followed by three potential scenarios for the likely impact on developing country economies of a marked decline in the U.S. external deficit. In the first scenario, the decline of the U.S. external deficit is fairly slow and steady and developing countries are able to substitute domestic demand growth for external demand growth and adjust without a recession. In the second scenario, U.S. aggregate demand for imports declines more severely because of slower economic growth and a smaller contribution of U.S. export growth to the closing of the external deficit. Chinese import demand growth is adversely affected and developing countries face a decline both in U.S. and Chinese import demand. In the third and last scenario, a sudden adjustment that generates a global financial tsunami, most likely triggered by a run on the dollar that leads to a spike in interest rates in the U.S. and a sharp drop in U.S. import demand, would transmit the downturn from the U.S. to the rest of the world.