Bottom Dollar

As more time passes with neither the value of the dollar declining sharply nor market forces beginning to shrink America’s current-account deficit — which may well reach $1 trillion this year — two diametrically opposed reactions are emerging. Most international finance economists are becoming increasingly frightened that a major international financial crisis could erupt. Indeed, they fear that the scale of that potential crisis is becoming larger and larger.

Others — especially managers of financial assets — are becoming increasingly convinced that economists don’t know very much, and that what they do know is of no use to traders like themselves. They see little reason to believe that current asset values and trade flows are not sustainable.

After all, they (or some of them) argue, the real GDP of the United States is growing by $400 billion per year, with about $270 billion going to labor and $130 billion to capital. Even after depreciation, that $130 billion of extra annual income is capitalized at about $1.5 trillion of wealth, so the current-account deficit, even at $1 trillion, is not overwhelmingly large. We Americans can sell off two-thirds of the increment to our wealth to finance imports and still be $500 billion better off this year than we were last year.

Moreover, the annual interest charged on the extra $1 trillion per year that Americans borrow from the rest of the world is about $50 billion — just one-eighth of annual economic growth, while the trade deficit is financed out of the growth of the value of capital. So what’s unsustainable? Why can’t the US current-account deficit remain at its 2006 value indefinitely?

The counterargument hinges on the difference between the current-account deficit and the trade deficit. The current-account deficit is equal to the trade deficit plus the cost of servicing the net international asset position: the net rent, interest, and dividends owed to foreigners who have invested their capital in the US. As time passes, deficits accumulate. As deficits accumulate, the cost of servicing the net international asset position grows.

Thus, in order to keep the current-account deficit stable, the trade deficit must shrink. And the only way for the trade deficit to shrink substantially is for net imports to fall, which requires either a relatively sharp decline in the value of the dollar, thereby raising import prices, or a depression in the US. Both outcomes would weaken demand for foreign goods by making Americans feel that they are too poor to buy them.

As a result, holders of dollar-denominated assets should be looking forward to two alternative scenarios. In one, the value of the dollar will be low; in the other, the US will be in a depression. In neither scenario does it make sense to hold huge amounts of dollar-denominated assets today. Therefore, foreign speculators should, any day now, dump their dollar-denominated assets onto the market, and so bring about the dollar decline that they so fear.

But foreign-currency speculators and international investors are not looking forward to either of these scenarios. They continue to hold very large positions in dollar-denominated assets, which they would not do if they thought the US faced a choice between a cheap dollar and a deep depression.

So, what alternative does the market see? And why is it so different from the possible scenarios that international financial economists see?

The answer appears to be that there is nobody in the financial centers of New York, London, Tokyo, Frankfurt, and Hong Kong who thinks it is their business to bet on a future flight from the dollar. Especially in times of crisis — and a sharp fall in US imports would imply a much more severe crisis for Asian and European exporters than it would for the US — the dollar is a currency that you run to, not from.

George Soros can bet on a run on the British pound. Thai import-export firms can bet on a run on the baht by accelerating their dollar receipts and delaying their dollar payouts. Everyone can bet on a run on the Argentine peso — a favorite sport of international financial speculators for a century and a half. But not the dollar. Not yet.

In other words, the market is betting that the dollar will fall gradually in the next five years, and that the US current-account deficit will narrow without a financial crisis. That is what happened in the late 1980’s, and in the late 1970’s, too. After all, God, it is said, protects children, fools, dogs, and the United States of America. But the odds on a soft landing are lengthening with each passing day.

J. Bradford DeLong, Professor of Economics at the University of California at Berkeley, was Assistant US Treasury Secretary during the Clinton administration.