Since 1997 we’ve seen three global financial earthquakes, with the current one being the biggest and most violent. Unfortunately, there’s no reason to believe we’ve come to the end of the string.

The most likely suspect for the next financial crisis is, of course, a dollar crash, which many international economic experts have been predicting for the past two decades. But what will trigger it? I’m going to argue here that the odds of a dollar crash will go up if and when it becomes apparent that the United States has lost its premier position as the global innovation leader.

Let me explain. Right now we seem to have entered a relatively calm period for the global economy. Quick and forceful government action over the past year has blunted the damage from the September 2008 bust. In particular, global trade is starting to rebound.

But the underlying financial and economic stresses which led to the current crisis are still in place. There has been little progress in overhauling financial regulation so far. More important, the pattern of global trade and financial flows has not noticeably changed. In particular, the United States continues to run an enormous trade gap, despite the deep recession. So even though the crisis was caused by excess debt, the current US trade gap of $400 billion per year has to be financed by lending from the rest of the world. It’s a bit like giving a glass of wine to someone who has a history of drunk driving.

Equally disturbing, the lack of savings in the United States has gotten worse rather than better during the downturn. Journalists have talked glowingly of the big jump in the household savings rate. But national savings, a more comprehensive figure that includes savings by government and businesses as well as households, has gone down. In fact, the national savings rate fell to only 10.9 percent in the first three quarters of 2009, the lowest level since the depths of the Great Depression. Similarly, the net national savings rate, which adjusts for depreciation, has dropped into negative territory—also something that has not happened since the 1930s. To put it another way, the US government is borrowing money and giving it to households and businesses, which are then tucking the money away out of a fear of what comes next. So it looks like household and business savings have gone up—but that’s just a mirage.

If the United States were any other country, its currency would be toast. The combination of a huge trade deficit, continued borrowing from the rest of the world, and depressed savings should be sending the dollar plunging through the floor. Instead, the dollar has drifted down—but measured by the US Federal Reserve’s price-adjusted exchange rate index, it’s about at the same level as it was in March 2008 or May 1995. In other words, the dollar is still within its long-term historical range.

How can we explain the persistent and surprising resilience of the dollar? Here’s where we get to the economics of innovation and global knowledge flows. Think about supply chains, which have become the dominant mechanism of global trade. From one perspective, a supply chain is a conveyor belt, where cheap goods and services flow from supplier countries to the large multinational corporations that organize the supply chains.

But, in fact, the conveyor belt moves in both directions: in order to get the cheap goods and services, the multinational has to transfer some knowledge or technology to the supplier countries. This is the knowledge necessary for the supplier to create a product or provide a service. It might be the knowledge required for making the wing of an aircraft, a computer chip, or a living room table. Or the multinational might provide knowledge that enables an overseas call center to respond to questions.

This trade—intangible assets for access to lower-priced goods and services—is not a one-time deal. Technologies advance, products evolve, and fashions change. That means the multinational must continually provide new knowledge to the supplier to stay current with the market. If the supplier ceases to get new knowledge from the multinational, the ties of the supply chain weaken and, in fact, the supplier may become a competitor.

It’s important to realize that this transfer of intangible assets is not picked up by the conventional trade statistics. No one tracks the flow of information from US purchasing executives to the Chinese factories that make shirts for American department stores or the rudder for the Boeing 787. But this information has real value.¹

These flows of intangible assets—technology, business knowledge, and market knowledge—are tremendously valuable to supplier countries such as China and India. Intangible assets can greatly accelerate the process of economic development. In fact, it’s clear that without supply chains and offshoring acting as conduits of knowledge from overseas, growth would have been a lot slower in these countries.

What does this have to do with the dollar? Imagine that the dollar plunged to half its current level against the yuan and the rupee. US-based corporations would then be far less interested in shipping their intangible assets overseas, because the benefits of offshoring would be less. And China and India would receive a constricted flow of intangible knowledge assets.

This may help explain why China, in particular, has continued to support the dollar by buying US Treasury securities. The relatively strong dollar keeps Chinese exports competitive and also maintains the value of China’s dollar-denominated reserves. But more important, supporting the dollar keeps it attractive for US-based companies to increase the extent of their offshoring in China, including opening up new R&D facilities. And that in turn keeps the flow of knowledge coming, including some of the most advanced technologies.

Conversely, if China stopped supporting the dollar and shifted to domestic-driven growth, it might be able to generate lots of jobs and raise living standards for its population. The flow of intangible knowledge assets from overseas, however, would slow down.

Now the problem becomes clear: this dynamic assumes that the multinationals continue to have new intangible assets to provide to their supply-chain partners. Unfortunately, there’s quite a bit of evidence suggesting that US-based companies have had an awful lot of trouble generating successful new products in recent years. In the pharmaceutical industry, “falling research productivity”—fewer new drugs despite increased levels of research—is the main reason why there have been so many drug company mergers.

But the “innovation shortfall” has been an issue in many other areas of technology as well over the past decade.² The United States is still the global innovation leader, but other countries are catching up. Indeed, many multinationals have been offshoring significant parts of their R&D to supplier countries.

If and when the United States loses its innovation lead—or more precisely, if and when US-based multinationals can no longer offer attractive intangible assets as “payment” to suppliers—the current supply chain-driven global economy will become less stable. The downward pressure on the dollar will increase, and the odds of a dollar crash will go up.

A dollar crash would be nasty for everyone. For the United States, it would mean soaring inflation and a falling standard of living, as imports became much more expensive. Foreign investors would become a lot less willing to finance US government deficits. The net result: the government would be forced to raise taxes and cut back on spending, which would inevitably mean less money for every part of the budget, including health care.

For supplier countries such as China and India, a dollar crash would reduce exports and cost jobs. Perhaps more important, it would substantially diminish the inward flow of intangibles that has helped propel their rapid expansion. The impact on long-term growth would not necessarily be felt right away, but there’s no way for these countries to quickly duplicate the depth of scientific and technical infrastructure found in the United States.

Are these outcomes inevitable? Hardly. The United States pours more money into R&D than does any other country. Moreover, the United States is still the country of choice for cutting-edge research in the life sciences, where many expect the next technological revolution to come from. If this research pays off in faster growth and new breakthrough products, then the danger of a dollar crash will recede. Foreign investors will assume that the United States can grow its way out of its debt and low savings.

But suppose present trends continue, and US innovation continues to decline? In that case, doubts will grow about the future rate of US growth, the national debt will look increasingly unsupportable, and a dollar collapse will begin to seem inevitable. Not a happy picture.

¹ For a lengthier explanation of the problems with tracking intangibles, see my story Unmasking the economy, Business Week, February 13, 2006.

² As shown in my article, Innovation, Interrupted, Business Week, June 15, 2009.

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