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?

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.