May 21, 2003

Why Oh Why Can't We Have a Better Press Corps? Part CCXXI

The New York Times beats up on the Bush administration Treasury:

... stature gap... Paul O'Neill the gaffe-prone... John Snow... credibilit... impaired... policies which are now discredited... credibility in question, Mr. Snow... antagonizing America's trading partners... dangerous confusion in currency markets...

I cannot disagree: for someone used to Bentsen-Rubin-Summers O'Neill and Snow seem a long, long, long way down. But then the Times tells why it is beating up on the Treasury Secretary, and in the process reveals how pitifully little those who write--and review, and edit--it know about finance and economics:

The dollar's decline... certainly amounts a vote of no confidence in America... it isn't as if Europe is attracting investment on its own merits...

This makes me want to say, "But... But... But..."

Over the past year investors have become convinced (rightly, I believe) that the Federal Reserve is seriously concerned about the dangers of deflation and is willing to keep interest rates low to prevent even a shadow of a chance of a full-scale deflation, while the European Central Bank is not. This means that European interest rates are likely to be significantly higher than American interest rates for years to come. This makes euro-denominated bonds more attractive--they pay higher interest rates after all. So investors sell dollar-denominated bonds and buy euro-denomninated bonds. The value of the dollar drops. The value of the euro rises. The value of the euro rises until fear balances greed: until the fear that the euro is overvalued and due for a correction (in which case owners of euro-denominated assets suffer a capital loss) is just enough to balance the higher interest payments on $1,000 invested in euro-denominated bonds.

Right now we are in the middle of this process. Investors and foreign-exchange traders are (slowly) recognizing that the difference in Federal Reserve and European Central Bank reactions to the recession has implications for forecasts of relative levels of interest rates years into the future. It is this relatively recent and ongoing recognition of important differences in policy that is at the root of most of the recent rise in the euro--and most of the recent decline in the dollar.

You see, Europe is attracting investment on its own merits: European interest rates are higher than American ones, and likely to stay higher for some time to come, hence euro-denominated bonds are relatively attractive.

But is there anyone who works on the Times editorial staff who read "...vote of no confidence... isn't as if Europe is attracting investment on its own merits..." and said, "Hey! Wait a minute! Elementary considerations of uncovered interest parity would have led one to expect a considerable decline of the dollar againt the euro!"? If there is, they are staying very, very quiet indeed.

Posted by DeLong at May 21, 2003 10:13 AM | TrackBack

Comments

Exactly. But of course America's gigantic balance of payments deficit offers another reason, this time more connected with a lack of confidence in America (the eurozone's trade with the rest of the world being much more in balance). Perhaps after 25 years or so of American balance of payments deficits (give or take the odd year) the rest of the world is finally getting tired of dollar assets (especially those that yield a mere 1.75%!)

Posted by: PJ on May 21, 2003 10:53 AM

Brad, how naive! Everybody knows there is only one market that counts - the equity market. It's there that European's can't hold a candle to the US. That is where the majority of international investment takes place -- isn't it? Well, maybe there is a big corporate bond market, too, but in that market it is relative growth prospects, not sovereign rates, that drive returns -- isn't it? Well, ok, there is a mortgage market, too, but the differences are so great in market structure that foreigners wouldn't be interested in buying US mortgage debt -- would they?

You have to not think about so many damned things to get this stuff wrong.

I do have one observation to make. That is that the period of euro appreciation vs the dollar is pretty much the period of rolling disaster - terrorist attacks on US soil, corporate hanky-panky, war and more war, world economies that can't get out of their own way, SARS... In such an environment, there will be big interest in safe haven investments - the short end of the sovereign debt markets. That is where the euro has the biggest spread over the dollar. The spread at 10 years has gotten wider lately (which suggests either that foreigners are buying long paper or scooping up some other US asset which is forcing US investors to settle for long paper), but is still not very wide. If safe haven incentives were to diminish, would the shift to euros slow, I wonder? I know the standard textbook treatment likes the risk-free asset (short as you can get), but I don't think that is all that international investors are willing to hold.

Posted by: K Harris on May 21, 2003 11:02 AM

"The short end of the sovereign debt markets. That is where the euro has the biggest spread over the dollar. The spread at 10 years has gotten wider lately (which suggests either that foreigners are buying long paper or scooping up some other US asset which is forcing US investors to settle for long paper), but is still not very wide."

Please explain further....

Posted by: dahl on May 21, 2003 11:23 AM

Theoretically, the FTD can be brought into balance by contraction or devaluation. Clearly, the Bush administration is not going to try to resolve the problem by restraining spending and increasing taxes. Their full scale abandoment of the Clinton Administration efforts to bolster national savings has exacerbated our FTD.

But can devaluation resolve the FTD without a wholesale resrtucturing of the U.S. economy? It seems to me that the U.S. is so dependent on importing goods that our imports are relatively inelastic. Our devaluation in comparison to Europe will certainly have no effect on the imports that we get from China unless, of course, we are prepared to set up Chinese-style manufacturing in the U.S. (we are not). Certainly, some of our key export sectors will be helped by the devaluation, but, it seems to me, not enough to counter the negative effect of a devaluation on the other end of the FTD equation.

But if we continue to rely on imports, as the value of the dollar decreases, the U.S. will have to "borrow" more money from other countries to pay the increasing costs of imports to the U.S., something that might increase our FTD.

Another concern I have with devaluation is the potential for a run on the dollar. Fortunately, East Asian countries have an overwhelming interest in propping up the dollar, but at some point, they may decide to cut their losses and abandon us leading to a freefall. In response, the Fed would raise interest rates, potentially bursting the property bubble and further devastating our economy.

In short, it seems that a little devaluation won't hurt, but the Bush administration best shy away from making it an official policy. There are less dangerous, more responsible, and more effective ways to resolve the FTD.

Posted by: Sean on May 21, 2003 11:51 AM

Theoretically, the FTD can be brought into balance by contraction or devaluation. Clearly, the Bush administration is not going to try to resolve the problem by restraining spending and increasing taxes. Their full scale abandoment of the Clinton Administration efforts to bolster national savings has exacerbated our FTD.

But can devaluation resolve the FTD without a wholesale resrtucturing of the U.S. economy? It seems to me that the U.S. is so dependent on importing goods that our imports are relatively inelastic. Our devaluation in comparison to Europe will certainly have no effect on the imports that we get from China unless, of course, we are prepared to set up Chinese-style manufacturing in the U.S. (we are not). Certainly, some of our key export sectors will be helped by the devaluation, but, it seems to me, not enough to counter the negative effect of a devaluation on the other end of the FTD equation.

But if we continue to rely on imports, as the value of the dollar decreases, the U.S. will have to "borrow" more money from other countries to pay the increasing costs of imports to the U.S., something that might increase our FTD.

Another concern I have with devaluation is the potential for a run on the dollar. Fortunately, East Asian countries have an overwhelming interest in propping up the dollar, but at some point, they may decide to cut their losses and abandon us leading to a freefall. In response, the Fed would raise interest rates, potentially bursting the property bubble and further devastating our economy.

In short, it seems that a little devaluation won't hurt, but the Bush administration best shy away from making it an official policy. There are less dangerous, more responsible, and more effective ways to resolve the FTD.

Posted by: Sean on May 21, 2003 11:51 AM

Theoretically, the FTD can be brought into balance by contraction or devaluation. Clearly, the Bush administration is not going to try to resolve the problem by restraining spending and increasing taxes. Their full scale abandoment of the Clinton Administration efforts to bolster national savings has exacerbated our FTD.

But can devaluation resolve the FTD without a wholesale resrtucturing of the U.S. economy? It seems to me that the U.S. is so dependent on importing goods that our imports are relatively inelastic. Our devaluation in comparison to Europe will certainly have no effect on the imports that we get from China unless, of course, we are prepared to set up Chinese-style manufacturing in the U.S. (we are not). Certainly, some of our key export sectors will be helped by the devaluation, but, it seems to me, not enough to counter the negative effect of a devaluation on the other end of the FTD equation.

But if we continue to rely on imports, as the value of the dollar decreases, the U.S. will have to "borrow" more money from other countries to pay the increasing costs of imports to the U.S., something that might increase our FTD.

Another concern I have with devaluation is the potential for a run on the dollar. Fortunately, East Asian countries have an overwhelming interest in propping up the dollar, but at some point, they may decide to cut their losses and abandon us leading to a freefall. In response, the Fed would raise interest rates, potentially bursting the property bubble and further devastating our economy.

In short, it seems that a little devaluation won't hurt, but the Bush administration best shy away from making it an official policy. There are less dangerous, more responsible, and more effective ways to resolve the FTD.

Posted by: Sean on May 21, 2003 11:53 AM

Brad's reference to higher yields attracting investment on its own merits to Europe is true, but truest for overnight rates. Fed funds are targeted at 1.25%. The ECB discount rate is 2.50%. That 1.25% difference makes the euro attractive. (Sorry, I know these are the basics, but you didn't tell me where to start.) German 10-year bunds are yielding roughly 3.72% (the average across the Eurozone is 3.71%, so Germany is as good an example as any). The US 10-year Treasury note is yielding about 3.35%. The difference at 10 years of 0.36% is a good bit smaller than the 1.25% difference in overnight rates. It is also less stable - the 36 basis point difference today is pretty wide by recent standards, and has at least something to do with Congressional failure to pass a debt limit increase - no new Treasury debt for now so there is a scarcity factory, and something today to do with Greenspan suggesting that the Fed might well be interested in buying longer-dated Treasury debt, like 10s. Wow, that has to be more than you wanted to know. Anyhow, the point is that the euro pays more than the dollar if the asset you hold is something like a bank account or a money market instrument, but not if the asset you hold is a 10-year note. When investors are scared (as they have been during the period I described), they notoriously prefer money market instruments. If the fear subsides, the higher yield of longer-dated debt will become more attractive. The US Treasury curve is steep - the difference between 2-year and 10-year yields was 2.03% at the end of trade on Tuesday - but has been flattening. That is a sign (scarcity of 10s and Greenspan's hint aside) that fear is subsiding. The recent rise in stock prices sends the same message. My question is, won't that make the yield differential on money market instruments between the US and Europe matter less? To some extent, that will depend on whether the rate differential at 10 years remains narrow.

Posted by: K Harris on May 21, 2003 11:59 AM

Brad - Fine but please first check the observed average inflation rate across the Eurozone over the last year. The last time I looked it was 2.3%. And which of the national economies in the Eurozone is reporting an actual fall in its consumer price index for the latest quarterly data available? None. If anything, it seems to me the real potential danger is stagflation - little GDP growth but with prices rising at an annual rate of c. 2%. I suspect that is closer to the ECB diagnosis than any belief that falling prices are an imminent threat.

Posted by: Bob Briant on May 21, 2003 12:07 PM

FWIW, I believe that Daniel Altman, a recent addition to the NYT Editorial Board, has an economics Ph.D. A Marty Feldstein student, if I'm not mistaken. So he's not a macroeconomist, but he should still know better (and should still educate his colleagues to know better) than to think that a falling dollar is a Bad Thing in and of itself, without regard to the context.

Posted by: Jesse on May 21, 2003 12:11 PM

By the by, when the dollar is trade-weighed against other currencies that decline in value is far less than against the Euro. Remember, China pegs its currency to the dollar and China is a major trade partner with us and a competitor in trade with others.

The dollar is falling against European currencies, but so is China's currency as well as other Asian currencies. Trade gains by America may be a lot than than we might hope.

http://epinet.org/content.cfm/webfeatures_snapshots

Posted by: anne on May 21, 2003 12:15 PM

Pardons to those who started to wade through my second post without realizing it was private correspondence. It should have begun with

Dahl, ...

Posted by: K Harris on May 21, 2003 12:45 PM

"The US Treasury curve is steep but has been flattening. That is a sign that fear is subsiding. The recent rise in stock prices sends the same message. My question is, won't that make the yield differential on money market instruments between the US and Europe matter less? To some extent, that will depend on whether the rate differential at 10 years remains narrow."

Interesting, but the public and private savings shortage in America would seem to insure further declines in the value of the dollar against the Euro. Stock valuations are better in Europe. So, why not buy Euros even for investing in stocks. Better valuations and a weakening dollar; seems a nice investment. Also, as Anne noted the dollar value decline against the Euro will have less impact on American trade than might be expected because of the dollar pegs in Asia. I say we buy the Euro.

Posted by: dahl on May 21, 2003 01:44 PM

You imagine that someone on the Times editorial staff has some idea what "elementary considerations of uncovered interest parity" are?

As I pointed out before, their number one military correspondent was off by a mere 400,000 (a factor of about 30) regarding the number of Soviet soldiers wounded in Afghanistan in multiple page one stories and nobody in-house ever caught that. I could give seemingly countless other examples just as bad. The Times' top editorial people are generalists in the extreme, masters at re-writing but expert on few subjects except by chance. The experts on fact and understanding are supposed to be the specialized reporters who make such howlers.

After all, the top editors can't be expert on everything they publish. They have to have faith in the quality of the people who come out of their now famous reporter-training program. And at the moment, reporting on interest rate effects is probably at the bottom of the priority list as far as that's concerned.

Posted by: Jim Glass on May 21, 2003 02:54 PM

Er...but Brad, back in 99, 00 and 01 no-one, not even you, was mentioning the theory of uncovered interest parity. Sterling is a good example in 1992-1995 of a currency with higher rates than another (the DM) but a collapsing external value.

Posted by: James on May 21, 2003 04:15 PM

A little help, please, for the non-economists reading this thread.

The US foreign trade deficit is, i believe, the difference between the value of US goods and services sold abroad and the value of foreign goods and services sold here. The US is a tremendous net importer.

So, all these foreign companies hold US dollars in US accounts. Balancing the capital accounts with the trade accounts, we see that net capital investment must equal net foreign trade deficit. [if any of this is wrong, please correct me.]

Now, I seem to hear on NPR once per quarter that the US is running ever larger trade deficits, and has done so for year after year. How large are these trade deficits in light of the US financial markets? How much US debt and equity is held by foreigners?

Also, is this trend sustainable? Should NPR be analyzing the pure dollar figure, or should it be looking at trade deficits as a percentage of GDP?

The value of the dollar plays straight into the size of the FTR, doesn't it, because a "strong dollar" policy lowers the price of imports?

So, an administration policy to weaken the dollar may reflect a view that the US cannot continue to sustain the capital inflows (perhaps because there are other more attractive places to invest), so it is time to reduce the FTR?

Is any of this correct?

Posted by: FDL on May 21, 2003 06:35 PM

A word about the dangers of deflation please sir!

It was on last Fridays PBS Wall Steet this Week with Fortune...

The Wall Street analyst said "I'm not afraid of deflation, why not, because the gas prices at end of street read $1.71 a gallon, that's why..."

It's all those "surcharges" the trucking companies (or transport industry--suit yourself dude) are charging now so that deflation is a word that Carl Rove produce Mr. Brad, you understand--it's misinformation with intent to do so...

Please show us that you really know what your talking about here. You are an economist professor, right sir?

Did you fall for that one hook, line and sinker?

Another thing PBS said is that interest rates will have to go up here in the USA...so then invest in international stocks (for stability), why because European stocks are not suicidal apparently...

Posted by: Cheryl on May 21, 2003 08:13 PM

A word about the dangers of deflation please sir!

It was on last Fridays PBS Wall Steet this Week with Fortune...

The Wall Street analyst said "I'm not afraid of deflation, why not, because the gas prices at end of street read $1.71 a gallon, that's why..."

It's all those "surcharges" the trucking companies (or transport industry--suit yourself dude) are charging now so that deflation is a word that Carl Rove produced Mr. Brad, you understand--it's misinformation with intent to do so...

Please show us that you really know what your talking about here. You are an economist professor, right sir?

Did you fall for that one hook, line and sinker?

Another thing PBS said is that interest rates will have to go up here in the USA...so then invest in international stocks (for stability), why because European stocks are not suicidal apparently...

Posted by: Cheryl on May 21, 2003 08:15 PM

A word about the dangers of deflation please sir!

It was on last Fridays PBS Wall Steet this Week with Fortune...

The Wall Street analyst said "I'm not afraid of deflation, why not, because the gas prices at end of street read $1.71 a gallon, that's why..."

It's all those "surcharges" the trucking companies (or transport industry--suit yourself dude) are charging now so that deflation is a word that Carl Rove produced Mr. Brad, you understand--it's misinformation with intent to do so...

Please show us that you really know what your talking about here. You are an economist professor, right sir?

Did you fall for that one hook, line and sinker?

Another thing PBS said is that interest rates will have to go up here in the USA...so then invest in international stocks (for stability), why because European stocks are not suicidal apparently...

Posted by: Cheryl on May 21, 2003 08:16 PM

oops...sorry, by computer is really slow tonight I guess...

Posted by: Cheryl on May 21, 2003 08:25 PM

Some interjections:
(1) Not really a gold bug, but one thing that could be pleasing euro supporters is that it is remarkably stable vs. gold, while the dollar is depreciating. Gold has been between a range of 300-350 euro for more than two years. (It's now towards the lower end, at 315 euro.) In that time the gold has gone from 260 usd to 370 usd.
(2) Having had the pleasure of predicting that the dollar would go lower at 1.05 (well, actually, 0.99, but 1.05 on my blog), it's pretty easy to see why. The U.S. is the only country which thinks of deflation as *the* great problem, where it is even willing to print money to avoid it. Well, just the suggestion that the government is going to print money, should rightly send investors in dollars to the exit gates. Better to run now, than run the risk of holding dollars which are suddenly twice as numerous.

Posted by: Andrew Boucher on May 21, 2003 11:51 PM

KH: I tried to do this flow-of-funds type analysis once and it didn't really work. Two problems:

1) With the swaps market the size it is, it's really quite difficult to tell what anyone's real exposure is or where the interest rate risk ends up. A quick glance at the quarterly results of the big prop trading houses in 1Q03 and 4Q02 suggests strongly that there are big carry trades out there.

2) As risk aversion rises, you get bond investors panicking into the short end of the curve, but equity investors panicking into the 10-year note (because various equity benchmarks use it as a "risk-free" proxy). Not always clear which effect dominates.

Posted by: dsquared on May 22, 2003 03:56 AM

Sean, anne, Dahl, you are only looking at the import side. U.S. products compete against European products overseas. The fall in the Euro makes U.S. exports more price competitive in these markets as well as in Europe.

With the fragile state of its economy, Europe probably can't afford to lose those exports nor sustain much of an increase in imports. Dollar drops against the Yen are even less welcome. There is potentially a negative feedback loop unfolding. Perhaps the adults will surface at some point?

Posted by: Stan on May 22, 2003 08:09 AM

To make it real simple - it's all about return on investment. And right now that return is better in Europe. Especially when it's relatively clear that it is US government policy to devalue the dollar. So, if you're buying US bonds or treasury notes not only are you getting less interest you're getting it in a devaluing currency.

Blech. The potential for a sudden free fall is actually quite high in a situation like this.

Posted by: Ian Welsh on May 22, 2003 07:21 PM
Post a comment