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August 30, 2005

The Future of the Dollar

It was in the late spring of 1985 that one of my elders explained to me that I was grossly ignorant: that the magnitude of the U.S. current account deficit was such that a hard landing was inevitable. Foreigners would be unwilling to finance the U.S. trade deficit for long. The dollar would fall. As the dollar fell, foreigners would demand high expected depreciation premia. As the dollar fell, rising import prices would push up American inflation. The FOMC would have no good options: it would have to choose inflation or recession--and if it was unlucky, it would have both plus financial crisis and depression as well.

I was convinced.

But somehow from 1987 to 1990 the U.S. made it through a 3-percentage-points-of-GDP decline in its trade deficit without a blip in inflation, and with barely a blip in asset prices and interest rates.

How was this reversal of two decades ago accomplished without severe macroeconomic upset? And is there anything different about today that makes the Plaza-Louvre experience a bad model?

Posted by DeLong at August 30, 2005 03:28 PM