Dollar Devaluation (pdf)

In the Financial Times this morning, Martin Feldstein, a Harvard economist, lays out the reasons for a steep devaluation of the U.S. dollar in order to correct all or part of the trade deficit. This, in addition to hints that China may buy less U.S. debt and George Soros forcasts the possibility of a recession in 2007, partly in response to trade deficits and currency devaluation (which, in addition, could spread the recession further afield than just the U.S.). It is a pessimistic, but realistic view that the continuing high twin deficits (feels like we're back in the 1980s), the budget and trade/current account deficis, are unsustainable. Combined with an inevitable correction in the housing market, which may or may not be smooth, predisposes the U.S. to an economic jolt, if not a full-blown recession. Sooner or later foreigners buying our debts will become worried about a sharp depreciation of the U.S. dollar, which will hurt the relative returns on the U.S. debt they hold, prompting them to get rid of U.S. dollar-denominated debt, which could even hasten a crisis. We are saved now by the reputation of the U.S., but sooner or later, unless the policies are changed, the economics will spring forth and it will be messy.