Sunday, September 23, 2007

Don't Look Down!

The greenback has sunk to parity with the Canadian loonie, and hit its all-time low against the Euro. In part, this reflects the Fed's interest rate cuts, which made investing in dollars less attractive. But the dollar's slippage does raise a bigger worry - that we could be headed for a current account "reversal." The the flip side of the US trade deficit (5.2% of GDP last quarter) is a "capital inflow" - in exchange for the goods they send us in excess of the goods we send them, our trading partners receive financial assets. That is, the US economy has become heavily dependent on borrowing from abroad. If our foreign creditors anticipate further declines in the dollar, they have an incentive to sell their US financial assets now... which would cause the dollar to fall further, which gives more reasons to unload dollar-denominated assets before everyone else does....

Or, as Paul Krugman asks, "Is This the Wile E. Coyote Moment?" There is considerable academic debate on the "sustainability" of our current account deficit (I seriously doubt it). If there is a reversal, does it come gradually, or all at once in an emerging-market style crisis? The upside of a dollar rout would be that exporting and import-competing industries would gain a price advantage over their foreign rivals (though it takes a while for exchange rate changes to "pass through" to consumer prices). The downside for consumers would be higher prices for imported goods (which would show up as inflation in our price indexes, presenting the Fed with a dilemma). More importantly, if the inflow of foreign finance is curtailed, long-term real interest rates would rise significantly.

Recall that GDP is the sum of government purchases (G), consumption (C), investment (I) and net exports (NX). The fact that NX is a negative number allows C + I + G to add up to more than 100% of GDP. The decline in the dollar would help with NX (our exports become cheaper to foreigners and imports become more expensive). Higher interest rates would reduce C and I. If the current situation is unsustainable, some rebalancing is necessary over the long run, but if it happens quickly, it could be quite unpleasant....

Krugman's asking the right question... has our ACME capital inflow kit (undoubtedly made in China) allowed us to run off the edge of a cliff? Is it time to turn to the kids watching at home and hold up a sign that says "gulp!"? However, if I'm correct on the laws of cartoon physics, we won't fall unless we look down.

On a related note, Ben Bernanke revisited his "savings glut" hypothesis of the current account deficit in a recent speech. This deserves more attention, but I'm not sure I'll get to it (fortunately, Econbrowser's Menzie Chinn did).

NB: the "current account" and trade deficits are not exactly the same, but they are closely related. The current account includes the trade deficit and also net income on foreign assets, but the trade deficit accounts for most of it.

Update (9/25): Here's The Economist's take (they're not so worried), and an op-ed by Morgan Stanley's Stephen Roach (who is worried).

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