It is unthinkable that the global economic system will continue indefinitely to allow the US to import more goods and services than it exports. At some point, the US will need to start repaying the enormous amount that it has received from the rest of the world. To do so, the US will need a trade surplus.

So the key determinant of the dollar's long-term value is that it must decline enough to shift the US trade balance from today's deficit to a surplus. That won't happen anytime soon, but it is the direction in which the trade balance must continue to move. And that means further depreciation of the dollar.

An important factor in this process will be the future price of oil and the extent of US dependence on oil imports. In each of the past four years, the US imported 3.6 billion barrels of oil. At the current price of more than $140 a barrel, that implies an import cost of more than $500 billion.

The higher the cost of oil, the lower the dollar has to be to achieve any given reduction in the size of the trade deficit. So a rising oil price as measured in euros or yen implies a greater dollar fall, and therefore an even higher oil price when stated in dollars.

There is one further important consideration in thinking about the future value of the dollar: relative inflation rates in the US and abroad. The US trade deficit depends on the real value of the dollar - that is, the value of the dollar adjusted for differences in price levels in the US and abroad.

If the US experiences higher inflation than our trading partners, the dollar's nominal value must fall even further just to maintain the same real value.

The inflation differential between the dollar and the euro is now relatively small - only about one percentage point a year - but is greater relative to the yen and lower relative to the renminbi and other high-inflation currencies. Over the longer run, however, inflation differentials could be a more significant force in determining the dollar's path.

The author is a professor of economics at Harvard

Project Syndicate

(China Daily August 7, 2008)