The Weak Dollar's Impossible Strength

Once upon a time, until 1997, America's current account deficit was relatively small--just 1% of GDP. Since then, the deficit has widened dramatically, to 2.7% of GDP in 1999, 3.5% in 2001, and an estimated 4.7% this year. Expect more of the same in 2004, when the current account deficit should reach 5.1% of GDP, despite forecasts that the US economy will grow significantly faster than most of its trading partners.

How long will the rest of the world continue to finance America's external deficit? What will happen when it stops doing so?

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Clearly, America's current account deficit is unsustainable. As the late economist Herb Stein, an advisor to President Richard Nixon, used to say, if something is unsustainable, then someday it will stop. I used to think that the US current account deficit would stop when the rest of the world "balanced up"--when Japan recovered from its decade-long stagnation, and when Western Europe restructured its economy, boosting aggregate demand and reducing its unemployment rate to some reasonable level. But with every passing year, "balancing up"--rapid growth in the rest of the world boosting demand for US exports--has become less and less likely.

The other way the current account deficit could come to an end is if the inflow of capital into America stops. As the late Rudi Dornbusch (who preceded me as the author of this series of commentaries) used to say, unsustainable capital inflows always last much longer than economists, who tend to focus firmly on the fundamentals, believe possible. Investors funding the capital inflow and the country receiving the money always think up reasons why this time the inflow is sustainable, because it reflects some supposed permanent transformation of fundamentals.

That mass delusion, Dornbusch argued, keeps the inflow going long after it should come to an end. But when it does end, the speed with which the capital flow turns around takes everyone--even fundamentals-watching economists--by surprise.

Whenever the capital-flow reversal hits the US, it is clear that the dollar's value will decline by 25-50%. The exact amount depends on how rapidly Americans re-direct their spending from imports to domestically-produced goods, and how much of an expected recovery in the dollar's exchange rate is needed to persuade investors to hold US assets while the spending switchover takes place.

In Mexico in 1995, in East Asia in 1997-1998, and in Argentina in 2002, the collapse of currency values caused enormous distress: as exchange rates fell, the local-currency value of debts owed to foreigners and linked in value to the dollar soared, raising the danger of effective national bankruptcy. Deep recessions, high real interest rates, and financial chaos were all on the menu--although the then US Treasury Secretary Robert Rubin, the IMF's Michel Camdessus and Stanley Fischer, and many Mexican and East Asian politicians and central bankers skillfully prevented at least the first two crises from becoming much more destructive than they might have been.

But should the value of the dollar suddenly collapse, the US will follow a different course. Like Mexico, East Asia, and Argentina, America's international debts are largely denominated in US dollars. Unlike in the case of Mexico, East Asia, and Argentina, the dollar is America's currency. Unlike other countries, a decline in the real value of the dollar reduces the real value of America's gross international debts.

A fall in the value of the dollar reduces Americans' standard of living, but it does not cause the kind of liquidity and solvency crises we have seen so often in the past decade--at least not if New York's major financial institutions have well-hedged derivative books; if not, all bets may be off. So an end to capital inflows to the US should not set off the worries about solvency and the derangement of finance that generated recessions in Mexico and East Asia and Argentina's deep depression.

The currency crises in Mexico, East Asia, and Argentina primarily impoverished workers who lost their jobs, those whose hard-currency debts suddenly ballooned, and rich-country investors who found themselves renegotiating terms with insolvent borrowers. A rapid decline in the dollar is likely to have a very different impact: primarily to impoverish workers whose products are exported to America and investors in dollar-denominated assets who see their portfolio values melting away. Dollar devaluation will only secondarily affect Americans who consume imported goods or who work in businesses that distribute imports to consumers.

So why, in the absence of solvency fears, do capital inflows to America continue? Investors outside the US can see the magnitude of the trade deficit, calculate the likely decline in the dollar required to eliminate it, and recognize that the interest rate and equity return differentials from investing in the US are insufficient to compensate for the risk that next month will be when capital inflows into America start to fall. The fact that so much of the risk from a decline in the dollar falls on those investing in America means that the capital inflow has already gone on much longer than any fundamentals-watching economist--including me--would have believed possible.

What stories are investors far from America now telling one another to justify continuing to add to their exposure to the risk of dollar depreciation? We know that sooner or later they will stop believing these stories, and we know what will happen when they do. But no economist can say when is "when."