Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: Yellen’s first Senate hearing, Biden’s inauguration, Europe’s small-loan buildup, and a look back at the Plaza Accord. To sign up for the Capital Note, follow this link. Biden’s Imperial Circle (part 2) In her first Senate hearing as the nominee for Secretary of the Treasury, Janet Yellen confirmed that she’d given up her old hawkishness on budgets, arguing that the U.S. has sufficient wiggle room to keep running fiscal deficits. She committed to working “over time” to pass Biden’s $1.9 trillion spending proposal. At the same time, Yellen reaffirmed the country’s commitment to flexible exchange rates, saying that “the value of the U.S. dollar and other currencies should be determined by markets” and that “the United States does not seek a weaker currency to gain competitive advantage.” Biden’s economic team has told us this much so far: the U.S. will continue to run deficits, the Fed will keep policy rates low, and the value of the dollar will fluctuate according to supply and demand. The latter point was meant to indicate that the Biden administration does not share Trump’s desire for a weaker dollar, but Biden takes office at a time when the dollar has persistently declined: Since June, the trade-weighted dollar index is down roughly 7 percent. And while the U.S. appears poised to post strong GDP growth over the next two years, it will likely do so in lockstep with most of the world’s major economies. Unlike the post-2008 recovery, which coincided with the European sovereign-debt crisis and periodic weakness in emerging markets, the post-pandemic world is headed for the “synchronized global growth” that economists hoped for in 2017. Expectations of strong recoveries in Asia and Europe partially explain the dollar’s recent slump. And with deficits ballooning, it will likely continue its decline as new issuances come to market at record-low yields. For decades, the U.S. economy has relied on what George Soros called the “Imperial Circle” whereby a strong dollar fueled foreign capital inflows that funded trade deficits and fiscal deficits, which in turn strengthened the dollar. For the first time in recent memory, this relationship appears at risk of breaking. While the U.S. is poised for a recovery fueled by fiscal policy, and markets are rallying, the foundations of domestic economic policy look shaky. If the dollar slides enough to meaningfully reduce capital inflows, we will either have to reduce our current-account deficits or let the dollar continue to weaken. As much as Trump complained about foreign-currency manipulation artificially propping up the U.S. dollar, the dollar’s strength has been a central pillar to stable growth despite persistent capital-account deficits. This is not to say that the dollar is anywhere near losing its reserve-currency status. On the contrary, dollar weakness reflects the success of policy-makers in flooding domestic and foreign markets with liquidity during the COVID-19 panic. The large chunk of foreign firms that borrows and invoices in dollars is benefiting from the current dollar downturn, and the pandemic should reinforce the Fed’s impressive capacity to act as global lender of last resort. But even with reserve-currency status, the dollar can weaken. And a weak dollar will make it harder to run current-account deficits year-in, year-out. Around the Web Yuval Levin on Biden’s Inauguration In its substance, as long as the cameras did not pan out too far, the ceremony nonetheless did radiate a sort of stability. Inauguration day marks a beginning and an ending, but it also marks a continuity. Presidents come and go, but the presidency persists. That continuity was much more palpable in this inaugural ceremony than in the last one, and by design. European regulators are concerned about a buildup of small loans Regulators fear a new—and potentially bigger—wave of defaults could send banks scrambling to cover losses. Weaker ones could require state help to survive. Andrea Enria, the head of banking supervision at the European Central Bank, has warned that bad loans in the eurozone could soar to as high as €1.4 trillion—more than during the aftermath of the financial crisis—if the economy contracts more than expected. The oversize exposure of banks to small businesses is part of Europe’s economic fabric. Companies with fewer than 250 employees account for 99.8% of all firms and two-thirds of all private-sector jobs in the European Union, according to the European Commission. Small businesses in the U.S. also have economic weight, but they tend to be bigger. About half of Europe’s workforce is employed by firms with fewer than 50 people, compared with about a quarter in the U.S., according to the U.S. Census Bureau. Random Walk The last time the Imperial Circle was at risk, policy-makers implemented a controlled devaluation of the U.S. dollar, which stabilized trade deficits. In a NBER Working Paper, Jeffrey Frankel explains: The “Plaza Accord” is best viewed not as the precise product of the meeting on September 22, 1985, but as shorthand for a historic change in US policy that began when James Baker became Treasury Secretary in January of that year. The change had the desired effect, bringing down the dollar and reducing the trade deficit. In recent years concerted foreign exchange intervention, of the sort undertaken by the G-7 in 1985 and periodically over the subsequent decade, has died out. Indeed the G-7 in 2013, fearing “currency manipulation,” specifically agreed to refrain from intervention in a sort of “anti-Plaza accord.” But some day coordinated foreign exchange intervention will return. To sign up for the Capital Note, follow this link.