Wednesday, April 13, 2005

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Be afraid but not too afraid about the dollar

Longtime readers of this blog will recognize my occasional concern with the size of the trade deficit and the future of the dollar. On this question, economists split into two clear camps -- camp one thinks the current equilibrium -- in which the U.S. runs enormous current account deficits and Pacific Rim central banks provide the financing for said deficits -- is incredibly fragile and that the dollar's value will fall hard, fast, and soon. The other camp thinks that because most actors in the system have a vested interest in seeing the status quo persist, the current equilibrium is more stable than many think, and that over time, the dollar's slow decline will help sort the system out.

Today the International Monetary fund follows up on the World Bank's warnings from last week and says that the current situation is not good. Andrew Balls provides a recap in the Financial Times:

The International Monetary Fund on Wednesday expressed frustration that rich and developing countries alike have failed to take the steps needed to reduce growing global imbalances.

The fund has long been calling for efforts to increase national savings in the US, including cutting the fiscal deficit, structural reforms to remove obstacles to growth in Europe and Japan, and greater exchange rate flexibility in Asia to boost domestic demand....

The fund forecasts that the US current account deficit will grow slightly to 5.8 per cent of gross domestic product this year, with little improvement thereafter. Germany and Japan are both forecast to have surpluses close to 3½ per cent of GDP.

“The US external deficit has so far been financed relatively easily, aided by continued financial globalisation,” the report said. “However, the demand for US assets is not unlimited... a continuing sharp rise in US net external liabilities will carry increasing risks.”

As well as the possibility of a disorderly decline in the dollar, the fund identifed the possibility that inflation pressures lead to a spike in US interest rates, and the high and volatile oil price as key risks to the global outlook.

The Bush administration's pledge to halve the US fiscal deficit is not credible, owing to a number of items left out of the budget arithmetic, and “insufficiently ambitious” in any case, the report said....

China increased its foreign reserves by $200bn last year, as it intervened to keep its currency pegged to the depreciating US dollar. Other developing countries have built up big foreign reserves - partly to insure against financial market risks, and partly to maintain trade competitiveness.

“A number of emerging markets, especially in Emerging Asia, have built up reserves to protect against everything short of the Apocalypse,” Mr Rajan [IMF chief economist] said, "The reserve build up is now undermining monetary control as well as the soundness of their financial systems.”

For more on the IMF's reaction, see the transcipt of their press conference, as well as a link to their World Economic Outlook: Globalization and External Imbalances. This quote by Rajan stands out from the press conference:

The U.S., if it does not cut its fiscal deficit—the fiscal deficit is just one part. The other part is savings; private household savings have to also contribute. The fiscal deficit itself may not be enough. If U.S. savings do not increase adequately, you basically have to borrow from abroad. At some point, investors outside will have a tremendous amount of U.S. assets in their portfolio and will start worrying about their value and about whether they are adequately diversified.

Essentially, to convince them to hold U.S. assets, one of two things has to happen: either U.S. interest rates have to go up way above the alternative opportunities these people have, or the U.S. exchange rate has to depreciate far enough that they feel that an appreciating exchange rate provides returns which give them incentives to hold U.S. assets. Neither of these is a particularly palatable outcome.

On the "don't panic" side, James Surowiecki has an essay in The New Yorker concluding that although a hard landing would be bad, it probably won't happen:

Markets are hardly known for their tenderness. Usually, you can assume that everyone in a market is trying to make as much money as possible, with as little risk, but the currency market isn’t like most others. In the market for the dollar, many of the players have other things on their mind. China needs to go on selling Americans hundreds of billions in exports in order to keep its economy humming. A weaker dollar makes that harder. Asian central banks also already own trillions of dollars in American assets. As the dollar falls, so does the value of those assets. There are plenty of other traders in the currency markets—who have the luxury of being single-minded regarding profit—but the Asian banks are powerful enough to be, in effect, the lenders of last resort. As long as it’s in their self-interest to keep America afloat, the dollar will not crash....

There’s a good chance, then, that the landing will be soft—we lose the truffles but keep our homes—as long as everyone involved in keeping the dollar aloft continues to play the same game. No one, in Asia or anywhere else, wants to be the last guy out. What the Chinese and the Japanese do depends in large part on what they think everyone else is going to do. If the Chinese get the idea that Japan’s commitment to the dollar is wavering, or if they decide that the United States has no interest in altering its deadbeat ways, then they may try to make a run for it. Then again, that threat could act as a prod to keep the Americans in line. The currency market is a great example of what George Soros calls “reflexivity”: people’s predictions about what will happen to the dollar end up having a major impact on what actually does happen to the dollar. Our lenders are trying to strike a delicate balance: they’d like the dollar’s predicament to seem dire enough to make us change, but not so dire as to spark panic. So be afraid. Just don’t be very afraid.

posted by Dan on 04.13.05 at 05:25 PM


Economists gotta problem in that foreign players here are acting in their political interests, i.e., in avoiding domestic change, rather than in their economic interests.

The Chinese government does not want its domestic consumption market to grow enough to absorb increasing Chinese productivity. There are lots of reasons for this which boil down to "that degree of increase in domestic consumption is not in the interests of the Chinese Communisty Party."

The governments of France and Germany do not want their economies to grow enough to threaten the particular domestic interests which support the current governments of France and Germany. While there are other factors which inhibit European growth, this is the biggie.

So the two biggest potential markets for an expansion in American exports to the degree necessary to grow out of the current trade imbalance are closed for domestic political reasons inside those markets.

The other ways to decrease America's trade imbalance are to reduce domestic demand and therefore domestic economic growth, or to institute some sort of forced savings mechanism with almost certain lessened domestic growth. These have their own political drawbacks.

People do not behave like money, and neither do governments.

posted by: Tom Holsinger on 04.13.05 at 05:25 PM [permalink]

While I an not a macro-economist, I do have eyes to see with and ears to hear with. Since the late 70's the Prophets of Doom have be preaching about the perils of the dollar imbalance and US oil comsumption leading to immediate collapse of Western Civilazation. After almost 30 years, the US and world economies are larger and healthier than ever. Errr, .....where's the collapse?

Perhaps their macro-economic models are all f**ked-up? I can remember when learned academics and petro-geologists still thought that oil was dinosoar-parts. .....Perhaps the economists are equally on the wrong track entirely??

posted by: Ted B. on 04.13.05 at 05:25 PM [permalink]

Nothing here a good recession like we used to have once every 3 years in the 50's wouldn't solve. Makes me pine for William Mc Chesney Martin. Yes, he left this country in great shape.

posted by: Richard Heddleson on 04.13.05 at 05:25 PM [permalink]

"Our lenders are trying to strike a delicate balance: they’d like the dollar’s predicament to seem dire enough to make us change, but not so dire as to spark panic." -- New Yorker

Ah, so it's a game of chicken? I think our Asian creditors will swerve first. Just yesterday the House decided to cut taxes again, even as spending continues to grow.

It appears it's up to the Chinese Communist Party to "starve the beast."

posted by: Carl on 04.13.05 at 05:25 PM [permalink]

Look at the stock market and you see the success of "starve the beast". Why would anyone ever think starve the beast would ever hurt the government before it did massive damage to the economy first?

posted by: spencer on 04.13.05 at 05:25 PM [permalink]

Look at the "Bretton Woods 2 is stable" scenario and calculate the percentage, 5 or 10 years out, of Treasury debt held by Asian central banks, as well as the US net international investment position at that time. You might prefer a hard landing tomorrow!

posted by: Jim M on 04.13.05 at 05:25 PM [permalink]

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