This time it’s different

Can we really say the U.S. is exempt from the same fate that befell other countries with unsustainable deficits? Well, yes, and this is the sense in which the Fed and the Treasury are begging the market, “Please don’t throw me in the briar patch, Br’er Fox.” None of the academic studies involves a country that has the world’s largest and freest economy, that is the sole military superpower, and that possesses the world’s largest financial markets boasting the highest liquidity, transparency and variety of instruments.

We honestly don’t know what constitutes “sustainability” regarding the U.S., and we don’t want to find out.

We don’t know whether the dollar should fall because of the current account deficit, but the attitude in Washington seems to be, "Let’s talk it down ahead of time, just in case."

Without some amelioration of the deficit today, by next year it could be 6.5 percent of GDP, 7.8 percent in 2008, or 13 percent by 2010, according to other studies cited by Summers. We know we can escape through the briar patch of devaluation, but we have no idea what we would do if the current account deficit was 13 percent of GDP and then the world’s investors decided to bail out of dollar assets. Other countries have survived such high deficits, but other countries don’t have the U.S.’s place in the world.

We have to ask whether the government talking the dollar down is just a precautionary measure. After all, you can argue the deficit is an integral part of the international monetary system today. Foreigners borrow in the dollar as well as hold it as a store of wealth.

In many instances, they use their store of wealth dollars as collateral for dollar debt. Recently the National Bureau of Economic Research sponsored a paper arguing the availability of these dollars “liberates” capital formation in poor countries from inefficient domestic financial markets. The economists say the empirical evidence (using China as a test case) bears out the idea.

This helps to explain why emerging market countries show an outflow of some $450 billion in the latest year to rich countries, which seems like an aberration, unless some of the capital is being recycled back to them in the form of collateralized debt.