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and rush to pass a massive increase in poorly thought-out regulation. Any such
response could seriously undermine the existing advantages of US markets and
reduce foreigners’ willingness to invest the massive sums of money required by
the US to support its current account deficit and capital outflows by US investors.
The dollar could quickly return to its downward spiral. This need not occur if critical
decisions on openness to foreign investment and financial market regulation
are driven by cooler minds instead of election-year politicking. It is critically
important that policymakers augment—instead of undermine—the long-term efficiency,
resiliency and openness of US financial markets. If foreigners lose interest
in investing in the US, additional reassuring words by Chairman Bernanke and
Secretary Paulson, and even coordinated intervention in currency markets, could
not support the dollar.
What Next for the Dollar? The Role of Foreigners 101

17 November 2008
Why are investors rushing to purchase US government securities when the US is
the epicentre of the financial crisis? This column attributes the paradox to key
emerging market economies’ exchange practices, which require reserves most
often invested in US government securities. America’s exorbitant privilege comes
with a cost and a responsibility that US policy makers should bear in mind as they
handle the crisis.
A familiar script has played as the global financial crisis has spread, picking up
speed and intensity. The drama has three acts that have been written out in the
historical record for as long as there have been open financial markets.
• Act One: Unbounded Enthusiasm. Some markets find favour with global
investors.1 Credit becomes readily available, asset prices percolate,
and many categories of spending are buoyed.
• Act Two: Day of Reckoning. Recognition that some of that enthusiasm
was overdone spreads among investors. New credit flows cease, collateral
is sought, asset prices crash, and prominent private-sector icons
• Act Three: Restoration. Here governments pick up the pieces, typically
passing on the cost to future generations by issuing a vast volume of
debt. The cost can be punishing because investors pull away from the
governments of emerging market economies as forcefully as they do
from private creditors.2
American exceptionalism
But there has been one prominent exception to this classic tale. With fitting irony,
the US, which is the epicentre of the crisis, has avoided Act Three. The US enjoyed
a capital inflow bonanza that funded yawning current account deficits, and asset
Is the US too big to fail?
Carmen M Reinhart and Vincent Reinhart
University of Maryland; American Enterprise Institute

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