The Dollar Can’t Do It Alone

It wasn’t supposed to be this way. Global rebalancing appears to be stymied. Nearly three years into the dollar’s correction and the US trade gap keeps hitting new records. The external deficit on goods and services widened to a staggering $60 billion in November 2004.
I’m old enough to remember when this would be a bad number for a year! This seemingly anomalous outcome reflects an important new shift in the macro fabric of the US economy — a diminished sensitivity to currency fluctuations. That means it will probably take more than just a weaker dollar to spark global rebalancing.

The diminished sensitivity of the US economy to currency fluctuations has been increasingly evident over the past 15 years. Normally, a weakening currency results in a narrowing of a nation’s current account deficit and a pick-up in inflation. That’s pretty much what happened in the 1970s and especially in the late 1980s in the aftermath of the dollar’s sharp downward adjustment during most of that latter period. But then it all seemed to change in the 1990s. The dollar’s decline in the first half of that decade was accompanied by a shift in the current account from surplus back to deficit. And inflation barely budged. A similar outcome has been evident in the past three years — a 16% decline in the broad dollar index (in real terms) accompanied by an ever-widening current-account deficit and persistently low inflation.

It’s not altogether clear why this relationship has broken down. My suspicion is that globalization is the main culprit.

more of this Stephen Roach article at morganstanley.com