Why the trade deficit is not a problem

Forbes has a great column on the account deficit:

The simple truth is that the current account and the capital account sum to zero in countries with floating exchange rates.

While economists can declare before God that the U.S. current account and capital account (adjusted for statistical discrepancies) must sum to zero, it is another matter to make pronouncements about the direction of causation between these two accounts. It can go either way. During the first half of 2005 the U.S. current account deficit was a breathtaking 6.4% of GDP. The dollar and bond bears (and most of the financial press) repeatedly cited the deficit number to support their gloomy prognostications. For them, changes in the capital account respond passively to changes in the current account.

The bears were proved wrong, suggesting that the direction of causation was running from the capital account to the current account. This explains why we could run a huge trade deficit without any collapse in the foreign exchange value of the dollar.

Hat tip to Don Luskin.