Dollars and Depression

The falling dollar has emerged as a source of profound global macroeconomic distress. But, unless and until foreign savers and investors stop financing the US current-account deficit, the world economy may dodge a potential catastrophe.

The falling dollar has emerged as a source of profound global macroeconomic distress. The question now is how bad that distress will become. Is the world economy at risk?

There are two possibilities. If global savers and investors expect the dollar’s depreciation to continue, they will flee the currency unless they are compensated appropriately for keeping their money in the US and its assets, implying that the gap between US and foreign interest rates will widen. As a result, the cost of capital in the US will soar, discouraging investment and reducing consumption spending as high interest rates depress the value of households’ principal assets: their houses.

The resulting recession might fuel further pessimism and cutbacks in spending, deepening the downturn. A US in recession would no longer serve as the world’s importer of last resort, which might send the rest of the world into recession as well. A world in which everybody expects a falling dollar is a world in economic crisis.

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