The wolf behind America's current account deficit

Because Asian currencies have been held down against the dollar, America's current-account deficit has continued to swell, reaching almost 6% of GDP in the second quarter.The dollar is already below most estimates of its fair value against the euro, but it will need to undershoot if the deficit is to be reduced. Economists at UBS estimate that the dollar's trade-weighted value might need to fall by another 20-30% to trim the deficit by enough to stabilise the ratio of America's external liabilities to GDP. Though it might seem unthinkable, that could imply a rate of around $1.70 against the euro (currently $1.28).

Supporting a deficit is a dangerous way to run the world, for it encourages both China and America to pursue reckless policies. Excessive liquidity is causing the Chinese economy to overheat. Meanwhile, by buying Treasury bonds, Asian central banks are subsidising American borrowing costs, encouraging more consumer profligacy, and so allowing the current-account deficit to get even bigger. The inevitable correction will then be all the more painful.

Until recently, some argued that America's current-account deficit was sustainable because foreign investors were eager to buy American assets to take advantage of the economy's faster productivity growth and hence its higher returns. But private inward investment has slumped, leaving America dependent on foreign central banks. And foreign savings are no longer financing investment and hence future productivity gains as they were in the late 1990s. Foreigners are now financing consumption and government borrowing.

America's current-account deficit largely reflects puny domestic saving, so dollar bulls often argue that a fall in the dollar is neither necessary nor sufficient to trim the deficit. But Stephen Roach, chief economist at Morgan Stanley, reckons that a weaker dollar would spark a rise in real bond yields, as foreign creditors demanded extra compensation for currency risk. That would slow consumer spending, boost saving and reduce the deficit.

In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stockmarket crashed. America's current-account deficit is now almost twice as big as it was then, so the total fall in the dollar—and the fall-out in other financial markets—could well be larger.