Were I to earn some Canadian dollars today they would be worth far
less than a U.S. dollar. In late 2001, the loonie dropped to 63 U.S. cents.
What happened to my beloved loonie?
For many years, particularly in the 1980s, Canada ran a large current
account deficit.6 In the post-1973 world, without governments control-
ling exchange rates under Bretton Woods, Canadaā™s current account
deficits were among the largest for an industrialized country. In other
words, Canada in the 1980s was consuming more than it produced to a
degree almost as extreme as the United States in 2004.
In the 1980s, Canada was enjoying its Wimpy burgers with the
promise of repayments on Tuesdays to come. The decline of the Cana-
dian dollar indicated that it was Tuesday and time for repayment. The
subsequent fall in the value of the Canadian dollar made Canadians less
able to import products from abroad. The cheap currency also made
Canadian products into excellent values. In short, Canada went through a
textbook process. Years of consuming more than it produced were fol-
lowed by repayment; this repayment, in the form of a current account
surplus, was accompanied by a cheap currency.
Canada consistently runs a current account surplus, and the adjust-
ment process was gradual.7 Over a quarter of a century, the Canadian
124 The Old Art of Macroeconomics
dollar fell from just over 1 U.S. dollar in 1976 to a low of 63 cents and
has remained below 75 U.S. cents for almost 10 years.
Canadaā™s adjustment process was not painless, but it was relatively
gradual and did not involve any panics. In contrast, Mexico took the
In the mid-1980s, my buddies and I used to make surf trips from San
Diego down to Mexicoā™s Baja peninsula. Along the way we saw advertise-
ments for Mexican investments āguaranteedā to return 40% per year. This
seemed like an amazing deal, and some of my friends took up the offers.
For a time, my surf friends earned high interest rates on their Mexican
investments. The process was very simple: Convert some U.S. dollars
into Mexican pesos and invest the pesos for a year. Earn 40% on your
pesos in a year, get them back, and convert your pesos into dollars. A
$1,000 investment returned $1,400 just 12 months later. Not too shabby!
Furthermore, the deposits were guaranteed to return 40% more pesos
There are few things more expensive than free lunches, especially in
the investing world. The catch is that the Mexican deposits were guaran-
teed to return 40% more in pesos. The dollar value of those pesos was not
guaranteed. Not to worry, though, how much can a peso devalue in a year?
As you might expect, this story involves the Mexican current account. In
the early 1990s, Mexico was running a current account deficit that was 7%
the size of its economy. As we have learned, such deficits are unsustainable
and the road to repayment usually includes devaluing the currency.
In late 1994, a Mexican peso was worth about 30 U.S. cents. One year
later it was worth about 12 cents.8 Now consider the 40% guaranteed
return on your peso investment. Your $1,000 still earns 40% in pesos, but
when the proceeds are converted back into dollars the investment returns
about a total of $500. Rather than earning a 40% positive return, this
āguaranteedā investment lost half its value in one year.
While the Mexican peso devaluation was bad for foreign investors, it
was a crisis for Mexicans and many others. In simplest terms, the adjust-
ment from current account deficit to surplus requires a change in wealth.
Deficits and Dollars 125
Both Canadians and Mexicans became poorer because of their currency
devaluations. The speed of the Mexican decline caused panic and severe
The U.S. current account deficits will end. The adjustment path can be
rocky or smooth. The U.S. situation is different, and in many ways better,
than either the Canadian or the Mexican current account deficits. These
differences lead many pundits to confidently predict a smooth path.
Because the U.S. current account deficit is the largest in history, however,
there is no precedent. Therefore predictions of the adjustment path are
simply speculations, some well grounded, but speculations nonetheless.
The Country with the Golden Brain
Since the United States is in a dominant economic position, perhaps the
best predictor of the coming current account adjustment lies neither north
nor south of the border, but in our own history. In the early 1980s, the
U.S. current account deficit reached then record highs (although Figure
6.1 shows that these deficits pale in comparison to more recent deficits).
What happened after record U.S. current account deficits in the early
1980s? Well, the most common effects of large current account deficits
are clear in this case. First, the current account deficits shrank. Second,
the move away from deficit was accompanied by a substantial weakening
of the dollar.9
This 1980sā™ bout of U.S. current account adjustment was very smooth;
much more like the Canadian experience than the Mexican peso crisis.
Should we then infer that the coming adjustment will also be relatively
smooth? Perhaps, but the current situation differs for two reasons. First,
the current U.S. deficits are much larger than those in the 1980s. Second,
in the last few decades the United States has moved from being the
worldā™s biggest creditor to the biggest debtor.
The protagonist in Alphonse Daudetā™s āMan with the Golden Brainā
is born with a skull full of precious metalā”his brain is literally made of
126 The Old Art of Macroeconomics
gold. Throughout his life, he spends his birthright to help his parents and
then his beautiful wife. He is particularly lavish with his spouse and
spoils her with gifts paid for by depleting his finite supply of metal. For
each purchase, he must remove part of his brain and sell the precious sup-
ply for cash.
When the man with the golden brainā™s wife dies, he spares no expense
on the funeral. On his way home from the cemetery, he stops to buy a pair
of blue satin boots. The store clerk hears a scream and rushes to find the
man clutching the boots in one hand, while the other hand is covered with
blood and contains gold scrapings at the ends of the nails. His golden
birthright was gone; his entire brain sold off bit by bit over the years.
In a far less dramatic manner, but to a far greater degree, over the last
several decades the United States has spent its golden treasure. Figure 6.2
depicts how the United States has changed from an international creditor
to a debtor. The figures are calculated by adding up all the U.S. invest-
ments abroad and then subtracting foreign investments in the United
U.S. Overseas Assets ($Bns)
* estimate from part of year
FIGURE 6.2 The United States Is the Biggest Debtor in the World
Source: U.S. Commerce Department
Deficits and Dollars 127
In the early 1980s, and throughout most of its history, the United
States was a creditor. The value of U.S. investments abroad exceeded the
value of foreignersā™ investments in the United States. The positive figure
in 1982 of $328 billion represented accumulated U.S. savings.
When a country runs a current account deficit, it is borrowing. In the
case of the United States, it began borrowing from a position of strength.
The early years of borrowing just reduced the savings that had built up
over decades. In the late 1990s and beyond, the growth in accumulated
debt became extreme. The U.S. debt to the world at the end of 2004 stood
at $3.5 trillion.
As with the current account deficit, the debt that the United States owes
to the world is the largest amount in history. As with other figures, there
are nuances where the figures are adjusted for the size of the economy and
the current value of the assets (the data in Figure 6.2 use the historical cost
of the investment, not the current market value). When these nuances are
taken into account, the trend is identical. The United States has had a dra-
matic change from global creditor (and saver) to debtor (and consumer).
Loan Sharks and Latin American Defaults
The accumulated U.S. debt to the rest of the world stands at $3.5 trillion.
While this is a lot of money to you and me, the real puzzle is why such a
small amount of debt is any trouble at all. After all, $3.5 trillion is only
about 3 monthsā™ worth of U.S. economic output.
Compared to how much individuals frequently borrow, the U.S. inter-
national debt seems small. For example, my brother in-law Henry racked
up about $150,000 in debts during graduate school. At the time, the loans
represented many years of income. However, his education allowed him
to become a physician so the borrowing was justified. When people bor-
row for houses, we borrow many yearsā™ worth of income.
Therefore, the puzzle is why such a puny amount as $3.5 trillion is
considered a problem for the United States. The answer, as my Harvard
128 The Old Art of Macroeconomics
Business School colleague Professor George Baker points out, is that the
amount of credit available is a function both of the income of the bor-
rower as well as the ability of the creditor to force repayment.
āCharlie, the bedbug took my thumb,ā says Paulie (played by Julia
Robertsā™ brother Eric) in The Pope of Greenwich Village. The ābedbugā is
the local Mafioso chief and by a series of poorly executed steps, Paulie
owes more than he can pay. The bedbug actually goes easy on Paulie
because of family connections. Nevertheless, debts that arenā™t repaid in
this world invite severe punishments.
Why would anyone borrow money from a loan shark? As one might
expect, people who borrow from loan sharks usually have no alternative.
Some desperate circumstance leads them to need money, and with all
other doors shut, the loan shark fills the void. The puzzle then is not why
people borrow from loan sharks, but why loan sharks are willing to loan
money when all others arenā™t.
The ability of the bedbug to take Paulieā™s thumb explains why loan
sharks will loan money to people who cannot borrow from anyone else.
Because loan sharks are willing to collect in extreme ways, most people
try really, really hard to repay them.
The financial situation of the borrower as well as the tools available to
collect debts are the keys to understanding credit limits. With this per-
spective, it is easy to see why the biggest loans in most peopleā™s lives are
associated with their houses. Banks lend a lot of money, relative to salary,
for housing because it is relatively easy for banks to get their money back
by repossessing the property. When creditors cannot take thumbs or
houses to ensure repayment, they are not willing to lend very much.
International lenders always have to consider the possibility of default.
In December 2001, Argentina defaulted on its loans and stopped repay-
ing agencies such as the International Monetary Fund. At the time,
Argentina owed more than $100 billion. Could Argentina repay these
debts? Absolutelyā”they represented about one yearā™s worth of produc-
tion.10 So just as a homeowner can pay down a similarly sized debt over
the years, Argentina could have repaid the money it owes.
Deficits and Dollars 129
But countries will default on loans when it is in their interest to stop
making payments, not when debts become too large. Argentinaā™s Presi-
dent NĆ©stor Kirchner said that he would rather bear the consequences of
default rather than cut spending; he stated that repayment would be āpay-
ing with the sweat and toil of the people.ā11
John Maynard Keynes said, āIf you owe your bank a hundred pounds,
you have a problem. But if you owe your bank a million pounds, it has.ā
The United States owes the world $3.5 trillion and Keynes suggests that
this is a bigger problem for the creditors than for the United States.
Because the creditors appreciate their trouble, they are reluctant to
loan even more. This is one reason why the U.S. debt is problematic even
though it is a relatively small sum for such a large economy. A second
reason is that no bank or country has the ability to come to the United
States and force repayment, so lending money to the United States relies
upon its good graces for repayment. By this second measure alone, the
United States is the worst sort of borrower. No one can force the United
States to repay debts.
While the United States looks like a bad debtor for these two reasons,
it has another feature that makes it a low risk for default. When it gobbles
down the worldā™s oil, cars, and other products, the United States issues
IOUs denominated in U.S. dollars. Now, guess who controls the ability to
create as many U.S. dollars as are needed to ensure repayment? The