September 18, 2003

The Economist Worries About a Dollar Crisis

The Economist worries about a dollar crisis:

Zanny Minton Beddoes: With no alternative engines ready to kick in, the dollar will have to play an even more important role in America's adjustment than it did in the 1980s, when it fell by 55% against the D-mark and 56% against the yen. Since its peak in 2002, the dollar has already fallen by a total of 8% against its trading partners. But that is nowhere near enough.

Many economists reckon that, in the absence of a shift in global demand patterns, it would need to fall by 40% or more to make a serious dent in America's current-account deficit. That kind of depreciation is hugely risky. The more a currency falls, the greater the danger that it will fall too far, too fast. A sudden dollar crash could roil financial markets and plunge the world into recession.

Moreover, the dollar is unlikely to fall evenly against other currencies. The Asian central banks' determination to stop their currencies rising has, so far, concentrated the dollar's fall on the euro, with a 20% drop against the European currency since early 2002 compared with 8% overall. A further, even bigger drop in the dollar, targeted on the euro, would probably sink Europe's economies...

The Economist is rather vague on the mechanisms by which a big rise in the euro would "sink Europe's economies." Europe's economies are open to each other, but not very open to the world at large. A rise in the euro against the dollar--even a big rise--should not do that much to aggregate demand in Europe. A fall in the value of the dollar ought to be more expansionary than contractionary for the United States--unless there are large unhedged derivatives books that threaten financial meltdown.

Posted by DeLong at September 18, 2003 02:06 PM | TrackBack

Comments

Unless you have a story like this. Economies (and central banks) are good at resisting to small expectable shocks. They're not so good at wedging large and unexpected shocks. To Europe as a whole, the shock would be (and already is) small.

But to Germany, quite open to the US, the shock would be sufficienty large to push it into serious recession. Then [some magic happens] the crisis gets transmitted to the rest of the EU. I guess the second part of the story would involve some kind of contagion cum multiplier story.

I hope my story does *not* make any sense...

Posted by: Jean-Philippe Stijns on September 18, 2003 02:17 PM

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1/ Tourism would fall.
2/ Airbus would sell fewer planes.
3/ Secondary houses would be more expensive (the Brits buying secondary houses in France and Spain earn these countries a fair amount of cash)
4/ Asian cars and consumer goods would be cheaper, so the homegrown variety would sell less.

So yes, a dollar at 1.35 euro would be very bad for Euro economies. On the other hand, 1.35 is less than 10% more than the introductary value of the Euro, so I don't think the Europeans can complain. (Mind you, the French of course are complaining already. See Le Monde,
http://www.lemonde.fr/article/0,5987,3234--334015-,00.html)

Posted by: Andrew Boucher on September 18, 2003 02:25 PM

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"...in the 1980s, when it fell by 55% against the D-mark and 56% against the yen."

Did any serious damage result from this fall then?

I'm not being rhetorical, just asking.

Posted by: Jim Glass on September 18, 2003 02:26 PM

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1/ Tourism would fall.
2/ Airbus would sell fewer planes.
3/ Secondary houses would be more expensive (the Brits buying secondary houses in France and Spain earn these countries a fair amount of cash)
4/ Asian cars and consumer goods would be cheaper, so the homegrown variety would sell less.

So yes, a dollar at 1.35 euro would be very bad for Euro economies. On the other hand, 1.35 is less than 10% more than the introductary value of the Euro, so I don't think the Europeans can complain. (Mind you, the French of course are complaining already. See Le Monde,
http://www.lemonde.fr/article/0,5987,3234--334015-,00.html)

Posted by: Andrew Boucher on September 18, 2003 02:30 PM

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1/ Tourism would fall.
2/ Airbus would sell fewer planes.
3/ Secondary houses would be more expensive (the Brits buying secondary houses in France and Spain earn these countries a fair amount of cash)
4/ Asian cars and consumer goods would be cheaper, so the homegrown variety would sell less.

So yes, a dollar at 1.35 euro would be very bad for Euro economies. On the other hand, 1.35 is less than 10% more than the introductary value of the Euro, so I don't think the Europeans can complain. (Mind you, the French of course are complaining already. See Le Monde,
http://www.lemonde.fr/article/0,5987,3234--334015-,00.html)

Posted by: Andrew Boucher on September 18, 2003 02:35 PM

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The reduction in European net exports could be offset by either (a) expansionary fiscal policy or (b) easier monetary policy. Alas, the EU fiscal regimes have foreclosed (a) and the ECB has not been that aggressive as far as (b). So the international Keynesian multipliers might be small under one set of policy responses, but isn't the fear that the United States of Europe with its de facto balanced budget amendments has the wrong policy regime?

Posted by: Hal McClure on September 18, 2003 02:59 PM

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hint: press post. wait awhile. if it does not return the text with your post- or a 404 error page, which is also ok, press the refresh button on the main web page and see if the number of comments posted has increased, in which case you're probably alright.

Posted by: john c. halasz on September 18, 2003 03:02 PM

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Re: hint
There's something more going on. On my first post, I pressed post once and left for the night. In the morning it was posted 8 times and people were not pleased as you might imagine. (Of course I previewed and edited it about that many times). [edited once]

Posted by: apav on September 18, 2003 03:30 PM

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This is kind of a weird notion. A set of circumstances a decade and a half to two decades old, compared to today with a claim that the magnitudes (in this case the magnitude of the dollar's role in adjustment) would "have to..." without even blinking. Why exactly would the dollar "have to..."? And didn't the magnitude of the dollar's fall in the mid-1980s have something to do with a deal reached in 1985 to push the dollar down, another in 1987 to stabilize it in case might overshoot? That is to say, wasn't the magnitude of the dollar's decline in the 1980s largely an engineering feat (one that makes Rubin's pale by comparison), rather than the natural result of macroeconomic forces and financial market trade? (OK, I'm happy to admit the policy effort woundn't have worked if economic forces hadn't helped) Why is what happened at least partly by design under rather different economic circumstances a pattern for what might happen of its own accord now?

I'd be interested in anybody elses answer to Jim's question, 'cause I don't recall any particular domestic disaster. After 1987, the US trade deficit did narrow for about 5 years, which was the idea. The manipulation occured in a pretty lengthy period of expansion. The stock market suffered a mighty hiccup that some attributed to a lack of commity over fx policy between the US Treasury Secretary and everybody in Europe, but that went away.

Posted by: K Harris on September 18, 2003 03:34 PM

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Unlike Keynes and Soros, I don't seem to be able to predict where currencies are going, which is why I'm not very very rich.

Posted by: Daniel on September 18, 2003 05:53 PM

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In reply to the queries raised by Jim and K Harris.

The queries reduce to two sets of questions: Were others harmed by the swift fall of the dollar's exchange rate (nominal and real, at least against the Yen and DM) after 1985 over the next several years? Was the US economy itself? In both cases, the answer is overwhelmingly negative. Consider each now.

I. WAS THEIR HARM TO OTHERS.

--- Not really, at any rate for industrial countries --- including the EU. For a chart of this, see http://europa.eu.int/comm/economy_finance/publications/european_economy/1999/eers0599chrtsen.pdf As you can see, the EU countries actually increased their GDP growth noticeably in the five year period after 1985 (1986-1990), when the dollar declined sharply against the DM and all the currencies of the other EU countries then tied to the DM in the European Snake, as opposed to the five year period, 1981-85, when the dollar soared.

--- I tried to find an equivalent source for Japan's GDP growth rate in the same period (1980s), but it wouldn't show properly in PDF for some reason; using the OECD's national accounts proved too arduous, ditto the IMF's; and the World Penn Tables are hard to wade through. Here, though, is another source that shows how fast the Japanese economy was growing in the late 1980s --- again, in the era of the rapidly declining dollar: http://oldfraser.lexi.net/publications/books/econ_free/countries/japan.html True, it doesn't show the period before 1988, but Japanese growth was much slower in the early 1980s. That much even I can remember.

--- In short, a plunge of the dollar in value comparable to what the Economist predicts needs to occur to adjust the US current account deficit in the future did take place in the late 1980s . . . without noticeable harm to the Japanese and EU economies. (Of course, you can always argue they would have grown faster with more export-led growth to the US economy; and maybe so. But at some point their economies would have overheated, most likely, and require tighter monetary policies to slow them down then.)
Note in passing that these conclusions refer to the Japan and the EU in those days (11 member countries). I leave it to others to examine what happened to the GDP growth rates of developing countries in the 1985 Ė 1990 period, or for that matter to around 1995 when the dollar was at an all-time low against the Japanese Yen, and the DM was even higher than in 1990 too in dollar terms.

II. WAS THEIR HARM TO THE US ECONOMY BECAUSE OF THE RAPID DECLINE IN THE DOLLAR'S VALUE IN THE LATE 1980S AND INTO THE EARLY 1990S?


--- Essentially no, a conclusion that a lengthy analysis of mine posted at this site the last couple of days tries to show, with lots of data and links: http://www.j-bradford-delong.net/movable_type/2003_archives/002249.html

Scroll down to Michael Gordon: there are four separate contributions in that exchange by me.

--- Only the conclusions are reproduced here:

"What Conclusions Can Be Inferred from the Experience of the 1980s?

1. Those who worry that the current US federal deficits will lead to some sort of semi-catastrophic hard landing of the American economy in trade and investment flows with the outside world ---- something, by the way, Paul Krugman thought the likelier outcome in the first edition of his book, The Age of Diminished Expectations ---- can find little or no justification in the outcome of the 1980s and early 1990s Reagan and Bush-Sr. deficits. That doesnít mean a hard landing is precluded. It does mean the only experience weíve had with prolonged structural federal deficits didnít end in the semi-catastrophe that the Jeremiahs of the 1980s and early 1990s predicted.

2, As for a prolonged rush out of the dollar by investors for whatever reason in the future, all that can be said is that itís unlikely to occur --- at any rate, to the extent that the experience of the 1980s and early 1990s is a guide. In particular, though the dollar fell by about 50% in value between 1986 and 1990, the rate of inflation did not increase, it decreased. Simultaneously, even as the dollar fell (with convergent efforts by the US Treasury and its equivalents in the EU and Japan to keep it falling), foreign investment inflows into the US continued at high rates even though net foreign investment inflows, of course, tapered off as the lower dollar brought about lower current account deficits. Long-term interest rates, moreover, werenít affected by the lower net investment inflow, it seems . . . any more than they rose as a result of the rapidly swelling Reagan and Bush-Sr. federal deficits. They didnít rise; they fell throughout the period of the 1980s and early 1990s.

3. As for the threat of a precipitous pull-out of Chinese or Japanese investments in this country --- presumably, this means central bank investments (though in the Chinese case, the Communist Party and the government can no doubt order private investors to do whatever they demand) --- that threat canít be excluded, but seems far-fetched. In the process of abruptly selling off their investments in US financial assets, they would see a rapid rise of the yen and the yuan no less abruptly occur, and hence find their dependence on export-led growth badly undercut . . . with no remotely equivalent market for their dependence on export sales as the major stimulus to their GDP growth to replace the US economy. They, official and private investors, keep most of their dollars earned on current account in the US economy out of self-interested behavior, finding it presumably a good economic bargain. And though they will from time to time adjust their portfolios and maybe sell off some dollars for, say, euros to invest in the EU ---- which is what presumably happened the last 18 months when the euro rose against the dollar until about June of this year --- there are limits to the attraction of euro financial assets compared to American . . . which is precisely why, since the start of June, the dollar has regained about 6% of its value against the euro. (To put it differently, the euro is still about 6% lower than it was at the time it was launched as a currency at the start of 1999.)

4 Though nobody can say now what will happen with much certainty to the size of the US federal deficit --- the Congressional Budget Officeís March projections of an unusually optimistic sort have been turned topsy-turvy by the growing burdens of financing defense, including the Iraqi war (as the CBO updated estimates of August showed) --- the experience of the 1980s and early 1990s suggests that a soft-landing of the sort DeLong believes in ---- not Krugman and some others --- is much likelier.


III. ADDED LATER IN A DUO OF POSTS WERE TWO OTHER CONCLUSIONS:

The First Added Conclusion: The fears expressed in this forum that a large, rapidly falling dollar would lead to a big rise in oil prices did not occur in the late 1980s. Exactly the opposite was the case. Specifically . . .


" Again, instead of fecklessly speculating in an intellectual vacuum as to what might happen to the oil price, we can at least find solid empirical ground in the 1980s . . . especially in the period after 1985, when the dollar declined rapidly and lost 50% of its value in nominal exchange rate terms. See http://www.wtrg.com/oil_graphs/crudeoilprice4797c.gif

1. Specifically, as a chart shows which tracks the price of oil per barrel in 1996 dollars since 1947 (down until 1998), you will find that the price of oil dropped noticebly even as the dollar itself fell sharply in value. It did rise rapidly in 1991, but as a result of the Gulf War,nothing else.

2. There's opposite evidence for the era of the high dollar after 1996. The dollar was now rising rapidly against other currencies in both nominal and real exchange rate terms --- especially against the DM and then the euro (oppositely against the smaller Asian currencies) --- and yet a price of oil per barrel almost tripled in price after 1999, at the height of the dollar's value. More specifically, the price about tripled by the start of 2001, then fell slightly, then rose, then fell, and has risen against to nearly $40 a barrel in the last month or so. (The chart doesn't show this, stopping at the end of 1997.)

3. So there's no correlation whatever between a fall in the exchange rate of the dollar --- in real or nominal terms (and presumably too on a trade-weighted basis) --- and a rising price of oil. Exactly the contrary, both in the 1980s and late 1990s.

4. One other point, missed by the worried Casandras here. Not only is there no correlation of the sort just analyzed, but the energy sector of the US economy --- thanks to much greater efficiency than in the 1970s and early 1980s --- has declined by about half: from roughly 7.0% of GDP to around 3.0 - 3.5% (depending on the vigor of economic growth). The upshot? Should a big rise in oil prices materialize--- even to the $60 level or so as in the late 1970s (in 1996 dollars) --- it would not have the same impact nearly on the US economy that the big jump in prices did in that decade.

5. For that matter, maybe unknown to the contributors here who have expressed worry, the price already has jumped from about $12 a barrel at the end of 1998 to around $40 a barrel, and the ripple effects on the US economy have hardly even been visible."


IV. THE OTHER CONCLUSION ADDED IN A LATER POST --- THE SIXTH CONCLUSION OVERALL OF THE ENTIRE ARGUMENT --- WAS THAT THE COMPARISONS BETWEEN WHAT MIGHT HAPPEN TO THE US IN THE FUTURE IF THERE WAS A BIG, BRUSQUE SELL-OFF OF THE DOLLAR --- LEADING TO A RAPID PLUNGE IN ITS EXCHANGE RATE --- WITH WHAT HAPPENED TO THAILAND AND OTHERS IN ASIA IN THE 1997-98 PERIOD OR LATER ARGENTINA IN THIS DECADE --- ARE FAR-FETCHED AND MISLEADING.

In particular:

" Much as I or anyone can regret what happened to the per capita income of average people in Thailand or the rest of SE Asia and some of North Asia, there is a huge difference between what they experienced and the causes of their currency and financial crash, and what the US is undergoing as foreign inflows of capital drive up the price of the dollar, or because of currency interventions by Japan and China and other Asian countries to keep their currencies undervalued.

1) In particular, Thailand and all the other Asian countries were obliged to pay back their loans of portfolio investment in dollars, not their own currencies. By contrast, the US runs up debt to foreigners --- based on mutually gainful economic transactions (foreign countries get export-surpluses with the US, which is what they want, plus a good outlet for investing their surplus dollars in the US eonomy; the US gets capital inflows to close the gap between our savings and investment rates) --- in dollars, our own currency, something we can never run out of.

2) The US continues to flourish better as a country with ongoing current account deficits than do countries like Japan, Germany, most of the rest of Asian countries, and most of the EU, all of which seek export-led growth and hanker after current account surpluses. Job growth in the US economy, though surprisingly lagging since 2001 --- owing to insufficient aggregate demand compared to the new potential output of the US economy (its long-term growth rate) --- is much better here than in those other countries or regions, and has been for decades. Similarly, GDP growth is much more vigorous here than in the EU or Japan, both badly stagnating --- Japan for a decade, the EU for two years (with a lower average GDP advance and growth in productivity than the US too throughout the 1990s).

Only neo-mercantilists can explain why countries with huge domestic markets --- the EU as a region, Japan, China, even South Korea --- continue to believe in the allures and magic of export-led growth, rather than domestic-generated growth.

3) As for productivity levels, the Bureau of Labor in 2002 found that US workers were by far the most productive in the world: each producing about $72,000 in output, compared to the next competitor, tiny Belgium (around 65%) Japanese workers produced about 60% of the US level.

4) Almost all the doomsday scenarios represented in these forums rely, in short, on either excessive fears or, possibly --- as in Krugman's case, where he was blatantly wrong about the future of the US economy in the 1990s in his book about it (published around 1990 or so in its first edition) --- wishful thinking. As with any economic trend, there are costs and benefits, each of which has to be measured carefully. The possible decline of the dollar, even a sharp one as in the late 1980s and early 1990s, is no different. Far from leading to catastrophe as Krugman and others predicted, itself a result, it was alleged, of growing fiscal profligacy (mounting national debt as a percentage of GDP), the US economy enjoyed in that decade of the 1990s its longest boom in history, a revival of its labor productivity to levels thought to be impossible by the declinists and doomsters, and the lowest levels of unemployment in 3 decades.

Why should we think that the doomsters will then be right this time?"

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 18, 2003 06:27 PM

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Running my eye rapidly over the post here, I note that I foolishly wrote "their" for "there" a couple of times. A stupid error, no? And no good excuse really --- only that I compose rapidly, fingers pounding hard, without any revisions . . . at any rate here and in other forums, as opposed to what I post at my own web-site.

-- Michael Gordon
http://www.thebuggyprofessor.org

Posted by: michael gordon on September 18, 2003 06:33 PM

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Odd: I posted a remark an hour or so ago, a brief one. It was to note the silly stupid faux pas of confusing "there" with "their". No excuse . . . only that I pound out these commentaries at lickety-split speed, fingers jabbing hard, with no revisions.


Sorry for the slip.

--- Michael Gordon
The Buggy Prof

Posted by: michael gordon on September 18, 2003 07:43 PM

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Droll.

Posted by: David on September 18, 2003 08:32 PM

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I'm was a bit young to remember much about the 80's but I remember that the fall against the Yen had a lot of political fallout and left the U.S. with bad feelings. I don't know the economic impacts of bad feelings but institutions that are suppose to facilitate trade and grease the economic wheel become ossified in that kind of political environment, doesn't it?

I agree with Jean-Phillipe, my TA for macro when I was an undergrad (I think), that Europe would be affected. The closed economies of 1980's are not the same closed economies of today. It's much more dynamic and liquid in many respects.

One question that'd be on my mind is would China break its peg with the U.S. if the dollar crashes. On the one hand, it would maintain the peg to keep the exports up, but the costs would be high. If they went that route, they'd hang on to their U.S. treasury bills.

But what if they go the other route and sell off their U.S. assets or stop buying U.S. assets (along with other countries)? I could be wrong, but wouldn't that be reflected in the U.S. current accounts and ultimately the GDP? It's hard to make the argument that our large CA deficit is going to productive investments these days. Investments might take a hit too with a sudden devaluation since rates might rise suddenly. A sudden forced adjustment to the current account, less investment, plus the higher prices of imports might be contractionary for the U.S. regardless of unhedged derivatives, I would think. I know the U.S. isn't a small open economy, but a lot of "on the margin" adjustments could have a pretty severe impact. But then again, I've never studied any of this in depth so please correct me.

Posted by: teddy on September 18, 2003 11:13 PM

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cassandra, n : (classical mythology) a prophetess in Troy during the Trojan War whose predictions were true but were never believed.

Posted by: PaulF on September 18, 2003 11:15 PM

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no, I have the reversed. The current account would become more positive, but consumption and investment might fall. We're talking about a large, unexpected drop that would raise risk in the eyes of investors and fear in the consumer.

Posted by: teddy on September 18, 2003 11:21 PM

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prof. delong:
redundant posts are jumping from comment section to comment section! that cassandra comment belongs several sections back, i think. could you please fix all this. their!

Posted by: john c. halasz on September 18, 2003 11:35 PM

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Teddy,

There is no saying that China will behave the same in some future instance as it did in the past. That said, during the emerging market currency and financial troubles of the late 1990s, China was called on to maintain its dollar peg in order to provide a sort of firewall against a second round of devaluations. China complied, even though it was not clear at the time that this decision was in China's interest. (Subsequent economic performance from China suggests maintaining the peg was in China's interest.) If there was a sharp US$ depreciation, having China stay pegged would reduce uncertainty, but would also mean china would be devaluing sharply against currencies other than the dollar. You'd hear howls from Asia and Europe.

Now, let's not hear any more bragging about not being old enough to remember the 1980s, you whipper-snapper.

Posted by: K Harris on September 19, 2003 07:08 AM

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>> That said, during the emerging market currency and financial troubles of the late 1990s, China was called on to maintain its dollar peg in order to provide a sort of firewall against a second round of devaluations. China complied, even though it was not clear at the time that this decision was in China's interest. <<

Devaluation of the RMB would have been devastating for Hong Kong. I don't know if that's the reason they chose not to devalue, but it was definitely a contributing factor.

Posted by: trevelyan on September 20, 2003 10:44 PM

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michael gordon wrote:

"Why should we think that the doomsters will then be right this time?""

Unfortunately this time the EU and Japan are both in relatively poor economic shape. The negative impact of our increased export competitiveness combined with their decreased imports into our market might well throw them back in the binder. Likewise, increased long term interest rates here could undermine our nascent recovery.

East Asia is looking better lately so maybe they can buy everybody's exports, send fewer themselves and everything will be hunky dorry (sp?). Admittedly I'm better with hindsight.

Posted by: Stan on September 23, 2003 02:16 PM

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A little late into the debate, but what's the latest score? Having seen the devastating effect of a confidence crisis, I am in the camp that the bias is tilting towards a USD crisis as the world just cannot continue to maintain confidence given the deficit numbers (C/A, budget, domestic debt). The non-US private sector have stopped with Asian central banks looking likely to hold the baby this time. The Fed can afford to adopt a benign neglect towards the USD...the Asian CBs will help it do the job in supoprting the greenback. In with Soros & Buffet on this one.

Posted by: sani on November 29, 2003 12:34 PM

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A little late into the debate, but what's the latest score? Having seen the devastating effect of a confidence crisis, I am in the camp that the bias is tilting towards a USD crisis as the world just cannot continue to maintain confidence given the deficit numbers (C/A, budget, domestic debt). The non-US private sector have stopped with Asian central banks looking likely to hold the baby this time. The Fed can afford to adopt a benign neglect towards the USD...the Asian CBs will help it do the job in supoprting the greenback. In with Soros & Buffet on this one.

Posted by: sani on November 29, 2003 12:35 PM

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A little late into the debate, but what's the latest score? Having seen the devastating effect of a confidence crisis, I am in the camp that the bias is tilting towards a USD crisis as the world just cannot continue to maintain confidence given the deficit numbers (C/A, budget, domestic debt). The non-US private sector have stopped with Asian central banks looking likely to hold the baby this time. The Fed can afford to adopt a benign neglect towards the USD...the Asian CBs will help it do the job in supoprting the greenback. In with Soros & Buffet on this one.

Posted by: sani on November 29, 2003 12:41 PM

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