Does A Current Account Correction Spell Doom?

Brad DeLong endorses an argument by Barry Eichengreen, published in the Financial Times, that foresees tough times ahead for the US economy.  Here's the Eichegreen argument, as is it appears in DeLong's post:

Narrowing the US [trade] deficit... require[s]... increased savings and lower investment. The falling dollar will bring this about by tending to drive interest rates up.... Asian central banks... sell some of their existing holdings... upward pressure on US Treasury yields.... [A]s the dollar falls, there will be upward pressure on US import prices.... [T]he Federal Reserve will have to raise interest rates faster than currently expected. Higher interest rates will make borrowing more expensive and slow investment growth. They will have a negative impact on... house prices. US households... will have to start saving again. With investment down and saving up, the current account deficit will narrow.

Unfortunately, this happy observation is not the end of the story. A significant decline in both consumption and investment will mean a recession in the US. This conclusion is so obvious that the only question is why the markets are not forecasting it already.

It seems to me that there is some mixing up of shifts in curves and movements along curves here. Here's what I mean by that.  Let's take as given the basic premise of the developments being described, and assume "Asian central banks... sell some of their existing holdings."  In other words, suppose foreigners want to shift their portfolios away from dollar-denominated assets, for whatever reason.  According to Eichengreen, reduced demand for the U.S. currency drives the dollar down and interest rates up.

So far, so good, but the relevant question at this point is "Why do interest rates increase?"  Here's my story.  The depreciation of the dollar makes exports cheaper to foreigners (making them want to purchase more of our goods and services) and makes imports more expensive to Americans (causing us to shift relatively more of our expenditures to domestic goods and services.)  For a given pace of GDP growth, domestic consumption, and domestic investment, this increase in net export demand means that there will be too much demand in the U.S. economy. 

Interest rates will rise, and as the story goes, reduce consumption and investment.   That's what is required to eliminate the mismatch between production and desired expenditure, which is a problem of, once again, too much demand.

The bottom line is this: There is a world of difference between falling investment and consumption growth that arises because spenders are pessimistic , or facing higher taxes, or whatever, and falling investment and consumption that is prompted by higher interest rates resulting from an excess demand for goods and services.  It seems to me that the latter is the relevant situation in the Eichengreen/DeLong scenario, and I don't think even conventional Keynesian-types are apt to predict recessions when the fundamental dynamics in the economy point to overheated demand.

Somehow the Fed gets wrapped up into all of this.  I agree it could be the case that  "[T]he Federal Reserve will have to raise interest rates faster than currently expected."  But as I explained here, a higher feds fund rate target in an environment of rising of market rates is not necessarily the same thing as tighter monetary policy.  And while it may true that the falling dollar and resulting current account adjustments could yield some upward pressure on the price level, those pressures should be temporary.  The FOMC has worked long and hard to keep such transitory ups and downs in the rate of inflation from becoming embedded in private expectations.  We can at least hope that Fed credibility will see us through whatever adjustments are to come, without the need for extraordinary measures to contain the inflation trend.

None of this to say that the reversal of our current account deficits will occur seamlessly, or without some sort of disruption to the U.S. economy.  The process I have described could certainly have many elements that make the road from here to there a rocky one. I just don't know.  But it is not at all clear to me that Eichengreen's "conclusion is so obvious that the only question is why the markets are not forecasting it already."