"The chapter on the fall of the rupee you may omit. It is somewhat too sensational." Oscar Wilde, The Importance of Being Earnest. What, one wonders, would Oscar Wilde's Miss Prism make of the fall of the dollar? Altering the path of the US external accounts, while sustaining global economic activity, is among the biggest challenges now confronting policymakers. The longer the adjustment is postponed, the more painful it is likely to be. What is needed is a co-operative solution, with changes made by all sides.

If such a solution is to be found, it is necessary to recognise, first, that a problem does exist, second, that it reflects the behaviour of most of the significant players in the world economy and, third, that a solution requires both changes in relative prices (that is, in real exchange rates) and changes in growth of supply and demand across the globe.

Reaching the needed enlightenment demands the elimination of the illusions that either the attractiveness of the US economy to foreign investors, or superior US rates of economic growth, or high US fiscal deficits are the cause of soaring external deficits.

Myth one - the deficit is driven by capital inflows attracted by high US real returns. The US current account deficit is close to 6 per cent of gross domestic product, while net external liabilities must now be close to 30 per cent of GDP. If foreigners were buying US assets because of attractive prospective real returns, it would be relatively easy to believe in the sustainability of these trends. Alas, this is not so.

At the macroeconomic level, the counterpart of the growing deficits has not been rising investment but declining savings. As Larry Summers, former US treasury secretary, has noted, "at 1.5 per cent, the [net] national savings rate is about half what it was in the late 1980s and early 1990s . . . . In fact, net investment has declined over the last four or five years in the US, suggesting that all of the deterioration of the current account deficit can be attributed to reduced savings and increased consumption rather than to increased investment".*

Furthermore, the financing of the deficit is also inconsistent with the view that investors are attracted by superior real returns. At the end of last year, US gross external liabilities were $10,515bn. Of this total, only 38 per cent took the form of direct investment or corporate equity - assets that would benefit from putatively higher real returns in the US (see chart). The rest consisted of bonds (both US Treasuries and corporate), bank loans and similar assets. But higher real returns in the economy and so higher real interest rates would lower the prices of longer dated securities denominated in US dollars.

The position on net assets is even starker: at the end of 2003, US net holdings of direct investment and equities were plus $729bn (see chart). Meanwhile, $1,206bn of US net liabilities (and so almost half the total) consisted of official reserves. Another $318bn was US currency. These holdings, again, had nothing to do with prospective returns on US real assets.

The US is, therefore, a net holder of claims on real assets abroad, but has large net liabilities in bonds (a big part of this in the form of official holdings) and cash. This is why the US continues to have a small positive net investment income, despite its large net liability position. This is not the position of a country that is attracting investors by the offer of superior real returns. More plausible motives are exchange-rate management by foreign governments and the search for a safe haven by foreign private investors.

Myth two - the deficit is caused by high economic growth in the US. A second explanation for the scale and persistence of the US deficit is faster US growth than in almost all other advanced economies. But fast growth does not necessarily generate large current account deficits. This is easy to see from China's experience, since the emerging Asian giant has persistently run current account surpluses.

What generates rising current account deficits is faster growth of demand than of supply. This has indeed been a persistent feature of US economic performance (see chart). Why then has demand been growing consistently faster than supply? The straightforward answer is an uncompetitive real exchange rate.

The source of the rising external deficit is not fast growth of output itself. It is, rather, that growth is biased towards the production of non-tradeable goods and services and away from the production of tradeables. With a more competitive real exchange rate, the US could enjoy the same rates of economic growth, but without having to generate still faster growth of demand. That, in turn, would halt (and possibly even reverse) the rise in the current account deficit.

Myth three - high US fiscal deficits are to blame. A third myth is that difficulties would disappear if only the US put its fiscal house in order. But if the fiscal deficit is t o be cut and the US economy is to avoid a deep recession, either the private sector financial deficit must expand, to fill the gap left by declining government borrowing, or the external deficit must fall.

If the former were the route, there would have to be a big boost to private spending, to take the private sector's financial deficit back towards 6 per cent of GDP, where it was in 2000. The only way to achieve this would be via a loosening of monetary policy and so, almost certainly, a decline in the dollar. If the latter were the route, there would also need to be a big depreciation, to shift output towards the production of tradeable goods and services and demand away from them.

Without such a depreciation, the adjustment of the current account could occur only through lower overall demand. But a back-of-the-envelope calculation suggests that a reduction in the current account deficit of one percentage point of GDP would then require a 6 per cent reduction in real domestic demand - in other words, a slump. Fiscal contraction would therefore have to be accompanied by a big depreciation of the real exchange rate.

What then is the bottom line? It is, first, that the current account deficit's trajectory cannot be explained away by positive features of the US economy. It is, second, that a big real depreciation of the dollar is inescapable if the trend is to be changed. The world must stop pretending that what is inevitable can be wished away. The challenge is, instead, to manage the adjustment to the needed changes in the exchange rate, while sustaining activity. Adjustment is coming. Let us co-operate to make it as smooth as possible.

* The US Current Account Deficit and the Global Economy, Per Jacobsson Lecture, October 3 2004, http://www.perjacobsson.org/2004/100304.pdf

martin.wolf@ft.com

Martin Wolf is a cornerstone of the Financial Times "Comment & Analysis" editorial group.  Look for more of his comment at www.ft.com