The December 2 issue of The Economist, included an article ("The Passing of the Buck?") that ends with this rather alarming historical analogy:
In 1913, at the height of its empire, Britain was the world's biggest creditor. Within 40 years, after two costly world wars and economic mismanagement, it became a net debtor and the dollar usurped sterling's role. Dislodging an incumbent currency can take years. Sterling maintained a central international role for at least half a century after America's GDP overtook Britain's at the end of the 19th century. But it did eventually lose that status.
If America continues on its current profligate path, the dollar is likely to suffer a similar fate.
Yikes! That sounds bad. But before we get too carried away, we should probably note that, by recent historical standards, this round of dollar depreciation is not that spectacular (thus far, anyway). Here's a picture (courtesy of Owen Humpage) that compares the dollar slide from its peak in February 2002 to the dollar depreciation in the mid-1980s.
Not that The Economist isn't on top of this one.
The dollar did indeed fall sharply in the late 1980s, but with few ill effects on the economy. So why worry more now? One good reason is that the current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s, and on current policies it will keep widening. Second, in the 1980s America was still a net foreign creditor. Today it has net foreign liabilities and these are expected to reach $3.3 trillion, or 28% of GDP, by the end of 2004...
Ok, but first, these really aren't two separate observations. Current account deficits are by definition financed by capital account surpluses, or an increase in net foreign liabilities. (In other words, if you import more than you export, you have to issue IOUs or equity claims to finance them.) So a string of current account deficits certainly does imply a growing stock of liabilities held by foreigners.
Second, as the following picture show, the current run-down in the dollar was preceded by a pretty impressive run-up. (As was the case in the 1980s.)
Third, as the picture also shows, the "correction" of the current account in the 1980s did not commence until well into the depreciation, so maybe a little patience is in order.
Am I arguing that all of the dollar anxiety is a non-issue? No, but the main villain assumed in most dollar decline stories today -- the federal deficit -- was also the presumptive bad guy in the mid-1980s. Even granting that this was an accurate view then (a discussion for another day), the policy response was a sequence of halting, but serious-minded, institutional reforms -- from Gramm-Rudman-Hollings, through the Budget Enforcement Acts in 1991 and 1993 -- that arguably helped to cure what ailed us. I'm not entirely sure why things are any scarier now than they were then, or why solutions that worked well in the past are any less practical today.
(For a really interesting discussion of the analogy between nineteenth-century Britain and the post-WWII United States referenced in the Economist article, see this book review by Niall Ferguson.)