The Falling Dollar

AHEAD OF THE TAPE
Why the Dollar Won't Regain Its Past Strength
October 3, 2007
By JUSTIN LAHART

(WSJ) America's heady deficit with the rest of the world has long looked like an accident waiting to happen. With the dollar's recent slide, it doesn't look like it's waiting anymore.

If such alarmism sounds familiar, it should. In 2004, the dollar was falling amid mounting worries about America's trade imbalance with the rest of the world. That year the U.S. current-account deficit -- a broad measure of the trade imbalance -- swelled to $640 billion, or 5.1% of gross domestic product.

Nouriel Roubini and Brad Setser, two academics who predicted a sharp decline in the dollar, became required reading on Wall Street desks.

Then in 2005, when everyone seemed to agree the dollar would fall further, it rallied instead. That put a temporary end to Wall Street's current-account obsession and singed a few hedge funds in the process.

Why should this time be different?

Worries about the current-account deficit have been popping up in currency markets for years. Broadly speaking, the deficit measures how much more the U.S. spends on goods and services from abroad than it earns on the goods and services it sells. To cover the difference, the U.S. is, in effect, borrowing from other countries. If they tire of this routine, they'll expect America to write bigger IOUs. The easiest way for that to happen is through a weaker dollar.

In practice, it seems like the current account is often just an after-the-fact explanation for declines in the dollar. The dollar bounces, and then something else grabs the market's attention.

What's different now, says Harvard University professor Kenneth Rogoff, is that the U.S. economy is looking weaker than many of its counterparts abroad.

At the moment, that's largely a housing story. In the longer term, he thinks it's also a productivity story. For a decade, heady U.S. productivity gains meant the U.S. economy could grow faster without fueling inflation -- a key reason for why it became such an attractive investment destination and why that unsustainable current-account deficit was sustained.

Now, productivity growth in the U.S. appears to be slowing. At the same time, the rest of the world has been adopting the technology and practices U.S. companies pioneered, boosting productivity abroad.

That means U.S. growth may be slower relative to that in other countries for some time, with the upshot that investing in the U.S. -- put another way, buying U.S. IOUs -- won't be as attractive as it once was.

In addition to pushing the currency lower, foreign investors could force U.S. interest rates higher relative to the rest of the world. Already, the spread between emerging-market bonds and U.S. Treasurys has narrowed substantially. They could also reduce the premium they'll pay for U.S. stocks relative to other stocks.

In late 2005, Mr. Rogoff and Berkeley professor Maurice Obstfeld calculated that the current-account adjustment could push the dollar down by 30% against the Fed's weighted basket of U.S. trading partners' currencies. Since then, it's fallen 11%, leaving about 20 percentage points to go. But rather than the sudden drop that current-account Cassandras sometimes envision, he expects the decline to be gradual.

"We're only going to see a radical adjustment if the U.S. tips into recession," he says.