Charge It!

Up to a point, a falling currency is a blessing. After that, it's a curse.

The dollar has fallen 16% against a basket of its trading partners' currencies over the past three years. In theory, that should, with time, make U.S.-made goods more competitive with those made abroad, boosting U.S. growth and employment.

But a growing chorus warns that the U.S.'s gaping budget and trade deficits will lead to a crisis in which the dollar falls much more sharply, driving up interest rates and squeezing the economy.

There are plenty of troubling precedents. Over the past decade, a dozen smaller economies from Mexico to Thailand have gone from growth to deep recession when their currencies collapsed. Even rich countries like Canada have been forced to adopt austere budget policies to cope with currency-induced turmoil. "We are increasingly vulnerable to the kind of sudden stop, where the capital inflows dry up all at once, that's been the bane of emerging markets over the years," says Barry Eichengreen, an economic historian at the University of California at Berkeley.

Could it happen here? It certainly hasn't yet. In a crisis, foreign investors dump stocks and bonds, fearing depreciation will cause further losses. Yet U.S. Treasury bond prices, and thus long-term interest rates that move in the opposite direction, have changed little in the last year -- and stocks are higher. A review of past crises world-wide suggests the U.S. has enough going for it now to avoid a similar fate. Yet the magnitude of the imbalances hanging over the dollar is also without precedent, suggesting a crisis remains possible.
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Mr. Roubini says the U.S. shares several of these vulnerabilities: large current-account and budget deficits -- nicknamed "twin deficits" -- with little prospect of resolution, and a growing portion of those deficits financed with short-term borrowing from foreigners. "The average emerging economy would have already gone belly up with these twin deficits," Mr. Roubini says. The U.S. has been spared, he says, because it can still borrow in dollars instead of foreign currency, meaning others bear the pain if the dollar depreciates. By contrast, developing countries often borrowed in dollars to take advantage of lower interest rates but faced a crushing repayment burden when they could no longer keep their currency pegged to the dollar. Brazil's Mr. Fraga notes fear of government default was a key contributor to its crisis, but that has "zero probability" in the U.S.

"We have some residual credibility," says Mr. Roubini. Nonetheless, U.S. dependence on short-term borrowing from foreigners "is becoming increasingly dangerous."
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Mr. Truman, now a scholar at the Institute for International Economics in Washington, predicts that in the next five years, the U.S. will have to intervene again "either because it's a period of disorder or because we can't withstand the political criticism from our partner countries." He adds: "The very richness and increased flexibility of markets that Alan Greenspan has emphasized probably translates into fewer episodes of disorder, but when they come, they're going to be bigger."