The United States' current-account deficit reached 5.7% of GDP in the second quarter of 2004. Yet the dollar remains at a relatively high value: less than 20% below its early 2001 highs and more than 10% higher in real terms than in the early to mid-1990's.
As the US current-account deficit rose over the past half-decade, international economists have lined up to predict doom: returns on assets invested in the US are relatively low, so at some point - probably all at once - holders of dollar-denominated securities will realize that the risk of suffering a major crash in value is not being adequately compensated. Once portfolio investors start selling their dollar-denominated securities, a stampede will follow, causing the dollar's value to crash and triggering the first major global financial crisis of the twenty-first century.
Fred Bergsten of the Institute for International Economics calls this situation "a disaster in the making." How far will the dollar have to fall? The first historical rule of thumb is 10% on the dollar for each percent of GDP's worth of unsustainable current-account deficit. The second historical rule of thumb is that currencies on the decline tend to overshoot: near the bottom, international currency speculators require a substantial risk premium out of the fear that the currency crash might trigger something even worse.
So when will this promised dollar collapse and crisis come? Bergsten says, "Soon."
But Bergsten is probably wrong about that. The late Rudiger Dornbusch - who used to write this column - used to say that unsustainable situations lasted longer than economists who believed in market rationality and equilibrium could imagine possible. They then tended to collapse more quickly than anyone could believe. In his view, currency overvaluations go through five stages:
· First, short-term speculators seeking higher returns, or investors overanxious for safety, drive a currency's value to unsustainable levels.
· Second, trend-chasers keep buying because the returns have been so good in the recent past, thus pushing the overvaluation to a height and duration that orthodox economists cannot explain.
· Third, highly intelligent economists, puzzled by the duration of the overvaluation, evolve theories of why things are different this time, and why this time the overvaluation is perhaps sustainable after all.
· Fourth, market bulls, encouraged by theories of a "new economy" that justify the extraordinarily good returns seen in the recent past, keep buying and keep the currency suspended above economic fundamentals even longer.
· Fifth, the supply of eager purchasers and trend-chasing investors comes to an end, producing a crash that resembles the collapse of a Ponzi scheme.
In the past six months, the current round of the US dollar cycle entered stage three. Louis Uchitelle of The New York Times quotes the highly intelligent Catherine Mann commenting on the "co-dependent relationship…between the US and its trading partners," which might "last for quite some time," because "the US and its main trading partners have a vested interest in the status quo."
Japan, China, and other export-oriented East Asian economies are indeed eager to keep the value of the dollar relatively high, and their central banks have piled up close to $2 trillion in dollar-denominated assets. China's government regards the threat of capital losses on its dollar-denominated securities as less important than the need to maintain near-full employment in coastal manufacturing cities like Shanghai. After all, the ruling communist oligarchs have grown accustomed to a comfortable lifestyle. The last thing they want is mass unemployment and urban unrest to call their positions into question.
But if international currency speculators get the scent of near-inevitable profits from an ongoing dollar decline in their nostrils, all Asian central banks together will not be able to keep the dollar high. Only the Federal Reserve can do that - and the Federal Reserve is very unlikely to sacrifice the jobs of American workers on the altar of the strong dollar.
There may yet be a soft landing, whether slow or fast: during the last major dollar cycle, between 1985 and 1987, the dollar fell by 40% without ever causing panic, major bankruptcies, or a demand by investors for a substantial dollar risk premium to compensate them for holding assets denominated in a declining currency. But the historical rule of thumb is that the chances of a fast, hard landing have now surpassed 25%, and continue to climb.