Crash or What? The Dollar and the U.S. Current Account Deficit

10/03/2005

One of my PhD classmates asked a question after our in-class presentation of Blanchard's NBER paper (w11137) that predicted the depreciation of the dollar, in the worst scenario, could be as much as 40% from today's level. His question was, "Why the heck the dollar would depreciate, cuz the demand for the dollar is so high, in foreign investmetn and trade? Is the prediction in contrast with our basic economic theory of supply and demand?"

My impulsive response was that he must be wrong. The high demand of the US assets just means more future income paid to the foreign investors, either in the forms of interest or dividend. As for the demand for the dollar in the international trade, the dollar just serves as the transaction facilitator. The demand for that purpose is much dependent on the velocity of circulation, not much on the volume of the trade.

But I don't feel it right. I actually hold some sympathy towards such a view. The dollar is indeed strong everywhere in the world. Asian central banks hold it; Saudi oil tycoons store it. Although the exchange rate of the dollar against the euro decreased to 1.20 recently, it may just reflect the fact that the euro was undervalued when it was debued in 2000.

To tell the truth, right from the start, I am not convinced of the idea of current account rebalancing. If the dollar remains strong, the reversal may never be realised. On one hand, the current account deficit has the potential to drag down the dollar; On the other hand, the strong preference/bias toward dollar lifts the dollar from the depreciation. So, when we talk about the relationship between the current account deficit and the dollar, first we should ask, "if there will be a depreciation", and second, "when the depreciation will be realised".

For small countries, the current scale of current account deficit in the US may have already triggered a crisis. But for the US, it may not be necessarily the case. With $200 billion reconstruction bill due to hurricane Katrina, the deficit may soon reach 7% of GDP. It's historically high. But how high the investors can bear before they lose confidence to the dollar, and the US economy? Remember, for the most of the developed world, the US is still the No. 1 choice to invest. Japan is recovering, but not so quickly; Europe needs serious structural reforms, not likely to come back soon either.

So the sharp depreciation of the dollar is not inevitable. It's just one of the scary theoretical scenarios our economists love to play with. Even if it happens, it can be a smooth landing. But the possibility indeed is there if the current deficit is still growing irresponsibly. Looks like we have gone back to the psychology of investment again -When will the investors ditch the dollar?


-Paul