Deficit up or dollar down?

China View quotes the Bush administration's plan to clear the budget deficit by 2012, but Reuters on 1st May quoted the Levy Economic Institute as saying this is unlikely, "barring a massive -- and unlikely -- further depreciation of the dollar".

Maybe that's the key, though. The Institute's April 2007 Strategic Analysis observes that a drop in the dollar leads to a nearly-equal increase in exports:

"Since the price elasticity of demand for U.S. exports is, by our reckoning, around 0.9, we expect quite a large positive response of export volumes to dollar depreciation."
However, the Congressional Budget Office's assumptions also imply a continuing increase in private borrowing, whereas the Institute expects the American consumer to cut back spending instead. If US household debt stabilises, the Institute's model deduces lower US economic output and a long period of higher unemployment, thus shrinking tax revenues. In that case, instead of being cancelled by 2012, the budget deficit increases.

A possible alternative government policy is depreciation of the dollar. Here is what the Institute says about that:

"... it would be quite unsafe to rely on this as an adjustment mechanism. First, we would have to be looking at a depreciation in the region of perhaps 30 percent, compared with the dollar’s most recent peak in 2002, and it might become impossible to ignore the inflationary consequences of such a great fall in value.

"Second, all of the econometrics indicate that there are long lags between changes in the exchange rate and consequential changes in real exports and imports, which will make it difficult to synchronize the rise in net export demand with the fall in domestic demand.

"Third, currency depreciation can no longer be regarded as a straightforward policy instrument, particularly if major surplus countries like China and Japan remain determined not to let their currencies appreciate."
Unlike the Institute, Warren Buffett, David Tice and Peter Schiff all seem to expect a major dollar drop. With inflationary consequences and, as in the second paragraph quoted above, economic dislocation.

But the third paragraph gives us more to think about. Is the Far East more concerned to maintain its trading advantage with the USA, or to preserve its capital while it builds up demand closer to home? There is already speculation about alternatives to the dollar as the world's reserve currency; I understand that foreign governments are building up their gold hoards; and I wonder whether the Federal Reserve is making contingency plans to issue loads more dollars to buy Treasury bonds if they are dumped by international holders?