Given current Asian government policies, the only thing that would bring US trade into balance would be tariffs high enough to make US goods competitive. We know what the consequences would be.

Even if the Fed were to raise interest rates high enough to bring the savings rate back above 8%, it’s not clear to me that in the face of the current Asian determination to run huge trade surpluses this would bring trade into balance. It seems more likely it would send the world into a deflationary death spiral.

In fact, it seems to me that what’s happening is that to maintain the average price level against the deflationary impact of Asian mercantilism the Fed is being forced to print so much money that inflation in the prices of non-tradeables (including assets) is inevitable.

There is a third way to increase the national saving rate – raise interest rates.

When people have money, they have a choice to spend it or to save it. Increasing interest rates, and restricting money supply, increases the demand for the currency and thus its price in relation to other goods and services.

An increase in interest rates will reduce consumption and increase saving. More people are likely to save if the interest rate is attractive enough.

It is my belief that monetary policy in the US has been too lax, even going back to the 1980s. Personal savings have been eroded because monetary policy has allowed inflation to punish savers while rewarding borrowers, it punishes producers while rewarding consumers. That is why the US has such a large current account deficit and why its consumption over the years has been driven by racking up debt.

As a result, I see the Fed’s response to the current problem to be precisely the wrong solution. It has been cheap money that caused this problem in the first place, so why is it suddenly the solution?

Of course, raising interest rates in the midst of a recession is a very dangerous thing to do. It may also be the only real solution in this case.

At issue is whether or not the deflationary effects of an economic contraction will outweigh the inflationary effects of the currency devaluation. Since many American economists can’t see beyond their own borders (as you said Americans still tend to do much of their thinking about the US economy as if it were either the entire world economy) the danger of inflation from a falling dollar is not understood properly.

When Asian currencies collapsed in the 1990s, the result was high levels of inflation coupled with recession. Although the US Dollar has not fallen as far (yet) the long term effects of a currency devaluation will always be inflation.

The forex market responded to the Bernanke rate cuts last year and this year with alarm. According to the NYBOT, the US Dollar has been trading at historic lows for a few months now. The dollar has fallen by about 10.5% in the last 12 months alone.

If Americans wish to save more and wish to avoid the inflationary problems of a falling currency, then interest rates will have to rise.