Doomsday for the Dollar?
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.
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