Consensus opinion

By now, everybody is talking about the dollar’s inevitable further decline, with even an august figure such as former Fed chairman Paul Volcker speaking of a 75 percent probability of a currency “crisis” sometime in the next five years. Publications ranging from The Economist, Business Week and Wall Street Journal to mass-market magazines and network TV news all solemnly declare the dollar is going to hell in a handbasket.

Traders flinch at such a consensus, because when everybody agrees and has already positioned himself short dollars, there’s nobody left to sell and push the price down.

But academics and some analysts flinch, too, because the global imbalance is not necessarily a bad thing.

Besides, devaluing the dollar won’t fix anything — the trade deficit will not improve by much. A 10 percent drop in the dollar induces less than a 10-percent (if any) improvement in the trade balance.

Growth in the U.S. generates more imports than growth in other countries. Even if all the major countries had the same growth rate, the U.S. would still import more than other countries would import, including from the U.S. Because correcting the current account imbalance is mostly a case of correcting the trade imbalance, the only way for the U.S. to export more than it imports would be to go into slower growth or even recession.

But the rest of the world relies on the U.S. for export-led growth, so if the U.S. imports less, other countries would go into relatively deeper recessions and import even less from the U.S. This is a real Catch-22.

So why do we have the Federal Reserve and the U.S. Treasury out on the conference circuit goading the foreign exchange market into a frenzy over the current account deficit? After all, the current account deficit has been growing steadily since 2000 — the dollar has gone up, down and sideways during the same period. (In fact, it has done all three in the past year.) These moves are not correlated with changes in the deficit.

The global imbalance obviously does not have a direct one-to-one relationship with the dollar. From an economic standpoint, in the typical tradedeficit situation, importers create an oversupply of the currency. In this case, the oversupply of dollars should make it less valuable. However, when demand for dollars is high for investment purposes, the power of the trade deficit to depress the dollar’s price becomes weak, and everybody knows it.

This is why, from a trader’s viewpoint, the monthly trade figures don’t contain useful information. These days, it’s the capital flow report that counts. In September, global investors were willing to increase their net holdings of dollar-denominated assets by 5.8 percent in a month when the dollar was falling by 1.3 percent. Crisis?

What crisis? We have no hard evidence anybody is unhappy about owning dollar denominated assets. In fact, the most recent Treasury capital flow report (Nov. 16) reports that net portfolio investment rose to $63.4 billion in September (from an upwardly-revised $59.9 billion in August). Net portfolio flows into the U.S. are averaging $72.2 billion per month so far this year, compared to $58.2 billion in 2003 and $47.9 billion in 2002. And the cumulative annual inflows are stunning — $649.5 billion in the first nine months of 2004: a 26 percent increase over 2003’s $514.5 billion. Considering the actual rate of return on short-dated money is zero or negative, this is quite a feat. China, for example, is sitting on $60 billion in dollar cash.

The capital inflows are more than enough to cover the current account deficit, which is running at an annual rate of about $665 billion. To speak of a funding crisis is to cry wolf, and Greenspan admits it:

“Current account imbalances, per se, need not be a problem, but cumulative deficits...raise more complex issues. Market forces should over time restore, without crises, a sustainable U.S. balance of payments. At least this is the experience of developed countries, which since 1980, have managed and eliminated large current account deficits, some in double digits, without major disruptions.”

“Sustainable” deficits is a reference to a study in 2000 by the Fed showing the outer limit of a current account deficit is about 5 percent, and after that, currency depreciation kicks in as an balancing mechanism (www.federalreserve.gov/pubs/ifdp/2000/692/default.htm). Deficits become unsustainable when they reach or surpass 5 percent of a nation’s GDP. The U.S. is beyond that point today.

The Q2 current account deficit stands at 5.7 percent of GDP, compared to the previous high of 4.5 percent in 2000 and 3.5 percent in 1986. The U.S. deficit is also about 1 percent of global GDP and more importantly, takes back, in the form of capital flows, about two-thirds of the cumulative current account surpluses of all the world’s surplus countries, according to Larry Summers, former Treasury Secretary and now President of Harvard University. The size is unique. No country has ever run such massive deficits before.