SYNOPSIS: Paul has a little disagreement with his friend and ally Stephen Roach of Morgan Stanley

As readers of my column know, I'm a great admirer of Morgan Stanley's Steve Roach. I think he's been right on many of the issues where he has stood against the conventional wisdom. I also think he's very brave. I offend a lot of people, but I live a quiet life in central New Jersey, and don't have to confront the people who hate me face to face. (I was worried about Mr. X, but now that the FBI has finally decided to search his apartment I'm a little less nervous about opening the mail.) Roach, on the other hand, has to face his detractors in boardrooms and conferences every day.

But I do have a small quibble with one thing Roach has been saying. Among his list of reasons for expecting a double dip is the U.S. current account deficit, which he says will force a contraction of domestic demand.

Now he's right that at some point the world will refuse to finance the CA deficit, and a necessary counterpart of a move to balance will be a fall in domestic demand. But will this be a drag on the economy? It seems as if Roach has forgotten that the counterpart of a fall in capital inflows is an increase in net exports: domestic demand must fall, but only to make room for that increase in net exports. Try taking a simple Mundell-Fleming model and putting in a risk premium on domestic bonds: r = r* + p. You'll find that an increase in p leads to a currency depreciation, but that output rises; domestic demand may fall, but only because the export-led expansion drives up the interest rate.

You might object that this conclusion is refuted by recent history. For example, when markets became unwilling to finance Indonesia's current account deficit, the result was a nasty economic slump. But the reason why currency depreciation was contractionary in Indonesia, Thailand, Argentina, etc. - or so current theory has it - was that so much domestic debt was denominated in foreign currency. This meant that when the rupiah or the peso fell, it devastated balance sheets, leading to an investment collapse that offset any pro-competitive effects of a weaker currency.

That won't happen here. A lot of nonsense has been written about the international role of the dollar: it is not true that foreigners are forced to take our bonds, that the U.S. can run current account deficits forever. (Foreign criminals like our $100 bills - but that's a limited thing, and anyway faces new competition from the euro.) But one thing is true: U.S. corporations carry debt that is denominated in dollars, and will not suffer balance-sheet problems when the dollar falls.

The rest of what Roach says seems to me entirely right. I think housing is having the moral equivalent of a bubble; I think households, suffering from Dow 36,000 illusion, have been saving far too little and will pull back as reality strikes. That's easily enough to warrant fears about double dip. But we're not Indonesia. Isn't that reassuring?

Originally published on the Official Paul Krugman Site, 8.2.02