Preventing a precipitous fall

Q. Why is the U.S. running a large trade deficit, and who is financing that deficit?

Q. Why are foreign central banks investing in the U.S., if not for high returns?

Q. When will foreign central banks stop financing the U.S.?  When will the tipping point occur?

Q. What can we do to prevent a precipitous fall?

Q. What happens if this financing stops?  What happens to my local community?

The dollar would fall. U.S. long-term interest rates would go up. The value of many financial assets would fall. The value of many homes would fall.

Those broad changes would reorient our economy over time. They would favor workers and communities that produce goods for export, or goods that compete with imports. They would hurt workers and communities that are favored by relatively low interest rates – those who work building homes, for example, or workers in a factory that makes windows for new homes. Those who borrowed a lot to buy a house might see the value of the house fall, making it difficult to move – and making home equity loans harder to get.

It would be far better – and far less disruptive – if these changes happened gradually rather than all at once, with expanding exports leading our trade deficit to fall gradually over time. The only way the trade deficit could suddenly be substantially reduced would be through a sharp fall in imports – in other words, a recession. Without sound policies in the U.S. and steps to support global demand abroad, there is a risk that we won’t be able to reorient our economy gradually, and will be forced to do so suddenly, and painfully.

Brad Setser is a research associate at the Global Economic Governance Programme at University College, Oxford and a blogger. E-mail: brad_setser@msn.com

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