Edmund Phelps, who I once said might have won the Noble Prize had he been Scandinavian, ventures a perspective on the dollar and the trade deficit.

This model revolves around the epochal event hanging over the present situation: the explosion over the next few decades of Medicare and Social Security outlays for the baby boom generation. The key point is simple: In any surprise-free scenario, or equilibrium path, the expectation of this future fiscal burden causes the U.S. current account to go into surplus — a surge of exports and import cutbacks — until the period when the baby boomers’ are exercising their huge medical and pension claims, during which the current account jumps into deficit. The logic is that the nation will do outsized saving in the early years to make room for the huge bulge of Medicare and OASDI (Old Age Survivor and Disability Insurance) claims that lie ahead; and since the global capital market is not going to place anything like the whole of that extra saving in U.S. capital, a large part of it must go overseas — in extra exports the income from which is invested abroad. The horde of overseas assets is gradually sold off as the boomers are exercising their claims. (Maybe those surpluses would run 1% to 2% of GDP.)

Correspondingly, the dollar will be far weaker in this scenario than that imagined by the optimists. It must weaken enough to shift the current account balance from today’s deficit not just toward a sustainable deficit level but to the needed surplus…

At the present time households are badly under-predicting their future tax liabilities — or, if the U.S. government is going to cut entitlements — over-predicting their future benefits. Either way, they are spending too much, so the current account cannot get out of deficit. Once households are better informed their spending and the dollar will both drop. (Yet budget and tax policy has to follow through.)

Because of our entitlement system, each of us is under the illusion that we do not have to save in order to meet our needs in old age. In the aggregate, however, this low saving is unsustainable.

For Discussion. How does this hypothesis relate to the debate over the effects of Social Security privatization?