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Worst-Case Scenario Is Not Pretty

America and the world have a lot to lose if we exhaust other countries’willingness to fund our borrow-and-spend tendencies.

Already, the huge volume of money that Washington and other governments printed in recent years is driving up demand for commodities well beyond the capacity of producers to meet it. From oil to corn to iron ore, prices of basic materials are soaring around the world. Except for food and fuel, most consumer prices do not fully reflect those higher basic prices, but this is not likely to continue indefinitely. Inflationary pressures are building that will likely lead central banks to raise interest rates, thus reducing demand and slowing economies around the globe in the next few years.

Despite globalization and growing concern about American policies, the United States and its dollar remain at the heart of the world’s financial system. Other nations accept our greenbacks in payment for their goods, then immediately invest those dollars in Treasury securities and other American financial instruments. This has helped keep U.S. borrowing costs low despite our chronically imbalanced trade and federal budget.

A worst-case scenario begins with foreigners becoming less willing to accept our dollars for their goods. A drop in the American currency’s exchange value would imperil trillions of dollars held by other countries as foreign-exchange reserves. These countries might try to salvage what they could by exchanging dollars for other currencies, starting a downward spiral. As the dollar’s value dropped, Americans would see the prices of foreign goods rise commensurately. Prices for oil and other essential imports would soar. This alone would slow the economy, but the Federal Reserve also would likely intervene by raising interest rates to reduce demand and stabilize the dollar. This, too, would reduce economic activity.

The United States probably would fall into a recession, perhaps deeper and longer than any we have seen in many years. If the world is very lucky, demand in other economies would remain strong enough to partly offset U.S. weakness. That would avert a global tailspin and would help moderate the American downturn. American workers could produce products for overseas buyers, while U.S.-based multinationals might continue earning healthy profits abroad. But this is an optimistic picture. Most large economies, including those of Japan, Germany and China, are geared toward satisfying overseas — primarily American — demand rather than domestic consumers, who are frugal by comparison. There is not much evidence that these economies are ready to pick up the slack if the American financial engine runs out of gas.

Some perspective is in order. Inflation and recession are bad things, especially when they combine in the condition known as “stagflation.” A bout of stagflation, while not assured, looks increasingly possible. This would be unpleasant, but can be survived and ultimately cured, as happened about 30 years ago. Yet I am not concerned about a repeat of the Great Depression. The policies and conditions that led to that disaster do not seem likely to recur.

If we experience a dollar debacle, there probably will be no place in the world economy in which to hide from it. But we can take some steps to mitigate the risk. As always, risk management starts with diversification — in this case, across countries, currencies and asset classes as well as companies. An inflationary spiral leading to, or accompanied by, recession probably will clobber all sorts of investment values, at least in the beginning. But eventually, stocks should recover as companies adjust to conditions, and hard assets may do relatively well.

Want to pick up an oil well or an office building as a hedge? That would be a good idea. But so might investing in a company that produces toothpaste. We have not seen a downturn yet that is so bad that people will stop brushing their teeth. Life goes on, even in recessions.