From 1995 to early 2002, the dollar rose by a trade-weighted average of about 40 percent. Largely as a result, the U.S. current account deficit grew by an average of about $70 billion annually for ten years. It exceeded $800 billion and 6 percent of GDP in 2006. This posed, and continues to pose, two major consequences for the world economy.
The first was the risk of international financial instability and economic turndown. To finance both its current account deficit and its own large foreign investments, the United States had to attract about $7 billion of foreign capital every working day. Any significant shortfall from that level of foreign demand for dollars would drive the exchange rate down, and U.S. inflation and interest rates up. With the U.S. economy near full employment but already having slowed, the result would be stagflation at best and perhaps a nasty recession.
The current travails of the U.S. economy are clearly related to these imbalances. The huge inflow of foreign capital to fund the external deficits held interest rates down and contributed significantly to the housing bubble that triggered the financial crisis and economic turndown. The sizeable slide of the dollar has indeed added to price increases, notably of oil as the producing countries seek to counter the losses it causes for their purchasing power, and thus greatly complicates the management of monetary policy as it tries to prevent a recession. The world economy is also adversely affected through the impact on other countries, as their currencies rise and they experience significant reductions in the trade surpluses on which their growth had come to depend.
Second is the domestic political risk of trade restrictions in the United States and thus disruption of the global trading system. Dollar overvaluation and the resulting external deficits are historically the most accurate leading indicators of U.S. protectionism because they drastically alter the domestic politics of the issue, adding to the pressures to enact new distortions and weakening pro-trade forces. These traditional factors are particularly toxic in the current context of strong anti-globalization sentiments and economic weakness. The spate of administrative actions against China over the past several years, and the numerous anti-China bills now under active consideration by the Congress, demonstrate the point graphically since China is by far the largest surplus country and its currency is so dramatically undervalued.
The U.S. current account deficit does not have to be eliminated. It needed to be cut roughly in half, however, to stabilize the ratio of U.S. foreign debt to GDP. That ratio was on an explosive path, which would have exceeded 50 percent within the next few years and an unprecedented 80 percent or so in ten. Avoiding such outcomes required improvement of about $400 billion from the levels reached by 2006.
The internal corollary is of course that U.S. domestic demand, initially residential investment but now also consumption, is rising more slowly than output. This inevitable reversal, after a decade in which internal demand climbed more sharply than production, means that the improving trade balance is cushioning the aggregate U.S. slowdown to an important extent. We are in fact experiencing the first episode of “reverse coupling,” through which the rest of the world continues to expand and pulls up the United States rather than being devastated by its turndown. This is an early indication of the shift in global economic weights, with the rapidly growing emerging markets now accounting for almost half of world output, as well as a timely unwinding of the chief global imbalance of the early twenty-first century.
I and colleagues at our Peterson Institute for International Economics have been pointing to these dangers since the end of the 1990s, and calling for corrective action that would include a very large decline in the exchange rate of the dollar. We were confident that such a decline would, as in the past, produce a substantial turnaround in the U.S. external position and it is now doing so. The current account deficit has fallen by more than $100 billion and is likely to drop by another $100 billion or so over the next couple of years. The fall of the dollar by 25–35 percent over the past six years, depending on which index is used, has sharply increased the international competitiveness of the U.S. economy. Exports have been growing at more than 8 percent annually for the past four years and by about 12 percent for the last two. Especially with the recent slowdown in U.S. growth, they are now expanding four times as fast as imports.