Why the dollar is different: Europe, Japan, and China, unlike the United States, are all locked into export-driven policies dependent on U.S. markets and competitively cheaper currencies. That's why there are likely limits to dollar depreciation.

• Author: Zoakos, Criton M.

Dr. C. Fred Bergsten, America's most authoritative proponent of the theory that the U.S. dollar is "'overvalued" and "overrated," on January 4, 2002, described the precise circumstances under which the dollar would be dethroned from its status as the world's international reserve currency.

Addressing the annual meeting of the American Economic Association, Bergsten argued that "at a fairly early point" the international net debtor position of the United States together with the growing current account deficit would trigger an average trade weighted depreciation of the dollar of about 20 percent, and a depreciation against the euro "of perhaps twice that much." This would "almost surely" induce a structural portfolio diversification of $0.5-$1 trillion in favor of the euro and at the expense of the dollar, and "would mark the arrival of the euro as a major competitor to the dollar" in the role of a world reserve currency.

As luck would have it, a mere 26 days after this speech the dollar began a major decline. Between January 31,2002, and June 15, 2003, the dollar depreciated by 23 percent against the index of all major trading currencies and by 38 percent against the euro, thereby meeting Dr. Bergsten's conditions. Nevertheless, not one of the consequences he predicted came to be.

Net portfolio capital inflows into the United States marked an all-time record high in 2002, and in 2003 to date are running $150 billion ahead of 2002. During May and June 2003, net portfolio capital inflows into the United States were running at an annualized rate of $1 trillion! Moreover, the status of the dollar as the world's international reserve currency has been strengthened. On April 2002, the dollar was 68 percent of international currency reserves, but in April 2003 it had further risen to 72 percent of international currency reserves.

This matter should give pause to any thoughtful person. The blunder was committed by a remarkable economist of formidable intellect, Dr. Bergsten, who, moreover, drew heavily from the work of Robert A. Mundell. Dr. Mundell was the 1999 Nobel Prize winner whom Bergsten cited extensively during his January 2002 presentation.

Why is it that contrary to the best economic theory, despite a stock market collapse that wiped out values the equivalent of 90 percent of GDP, despite growing current account and budget deficits, despite the massive body blow of September 11, despite a momentary decline of its exchange rate, despite (an admittedly mild) recession, and despite two major wars, the U.S. dollar today is more of a world reserve currency than it was before these events happened? And why is it that the dollar attracts even greater surpluses of foreign capital that outran trade deficits by about $100 billion per year?

The short answer is that the U.S. economy differs from all other economies in a crucial respect. The growth driver of the U.S. economy is a unique combination of entrepreneurship and high technology; the growth driver of every other economy is export demand.

Europe, Japan, China, and the Asia-Pacific region are all export-driven economies whose growth depends on U.S. markets. The U.S. economy depends for its growth on internal, entrepreneurial high-tech ferment. So long as this ferment keeps providing rates of return on capital higher than those in the rest of the world, international demand for U.S. investment assets will continue to be higher than U.S. demand for foreign goods and services. And American capital account surpluses will continue to cause American current account deficits.

More important, however, is the question: Is there a prospect for exchange rate stability anytime in the future? Where is the international system of currency exchanges heading, given this growing difference between the U.S. economy and the rest of the world?

THE NEXT TWELVE MONTHS

According to consensus estimates, a year from now the U.S. economy will likely be expanding at its sustainable 4 percent GDP growth rate or higher, Japan at about 2 percent, and the Eurozone at 0 percent. The official forecasts of the central banking authorities of the three areas more or less concur. The foreign exchange markets, however, have not priced into the exchange rates these consensus forecasts for a simple reason: there is widespread disagreement about the future course of inflation/deflation rates in the U.S. dollar area.

Simply put, the bond market in the United States believes that the Federal Reserves's commitment to keeping short rates low for a long time will produce inflation down the road. From mid-June to date, the yield of the ten-year bond increased by 84 basis points and the spread between the three-month Treasury bill and the ten-year bond widened by 77 basis points, resulting in a yield curve quite steep by historical standards.

This is not the first time...