November 16, 2004

Edmund Andrews Writes About the Dollar

Edmund Andrews writes about the dollar:

The New York Times > Business > Economic Analysis: The Dollar Is Down, but Should Anyone Care?: The United States is spending nearly $600 billion more a year than it produces, almost 6 percent of its annual gross domestic product. Much of that spending has been financed by Asian governments, which bought more than $1 trillion in Treasury securities and other dollar assets in the last two years to help keep the dollar strong against Asian currencies. Many analysts expect the financing gap to widen and the dollar to decline further. But there are at least three schools of thought on whether a dollar collapse is likely and, if it happens, what it would mean.

One group, which includes the Federal Reserve chairman, Alan Greenspan, contends that global financial markets are awash in so much money that the United States can borrow much more than seemed possible 20 years ago. The dollar may well decline in value, according to this view, but the decline would be gradual...

The Bush administration goes one step further, arguing that America's huge foreign debt simply reflects the eagerness of others to invest here.

"Productivity has been remarkably high in the last few years," John Taylor, deputy secretary of the Treasury, said at a recent conference. "Foreigners want to invest in the United States. That's what that gap illustrates."

A second school of thought holds that foreign governments like China and Japan will continue to finance American borrowing and keep the dollar strong because they are determined to sustain their exports and create jobs.

But a third school, which includes officials at the International Monetary Fund, worries about a collapse in the dollar that would send shock waves through the global economy. That group argues that the dollar needs to depreciate another 20 percent against the other major currencies but warns about a run on the dollar that could reduce its value by 40 percent. A collapse of that size would severely affect Europe and Asia, which have relied heavily on exports to the United States for their growth.

A steep drop in the dollar could lead to higher interest rates for the federal government and American private borrowers, as foreign investors demanded higher returns to compensate for higher risk. And it could expose hidden weaknesses among financial institutions and hedge funds caught unprepared.

"There is a school of thought that the U.S. can keep borrowing forever," said Kenneth S. Rogoff, professor of economics at Harvard University and a former chief economist at the I.M.F. "But if you add up all the excess saving being thrown out by the surplus countries, from China to Germany, the United States is soaking up three-quarters of it right now."

For Mr. Rogoff and several other economists, the question is not whether the dollar declines - but how fast and how far the fall turns out to be.... [W]here Mr. Rogoff predicts that the dollar will slide sharply over the next two years, Ms. Mann predicts that Asian countries will continue to subsidize American imbalances to keep their economies growing. A decline in the dollar may be likely, but not a panicky flight by foreign investors....

The dollar rebounded strongly in the early and mid-1980's in response to higher American interest rates, but then plunged 40 percent after leaders from the United States, Japan and Europe reached the so-called Plaza Accord in 1986 to nudge the dollar back down. The plunge after the Plaza Accord caused few disruptions for Americans, and foreign investors did not demand higher interest rates on securities. "One theory is that investors were simply irrational," said J. Bradford DeLong, a professor of economics at the University of California, Berkeley. "Others said it was the result of what Charles DeGaulle called the 'exorbitant privilege' of being able to repay your debts in your own currency."

Some economists contend that the United States can postpone its day of reckoning for years. Richard N. Cooper, a professor of economics at Harvard, said the global pool of savings was about 10 times the United States' appetite for foreign capital last year and growing fast enough to easily finance $500 billion a year. The wild card is that most of the money is coming not from private investors but from foreign governments, led by Japan and China. Rather than profits, their goal has been to stabilize exchange rates and keep their exports from becoming more expensive....

Andrews shouldn't have given Taylor so loose a leash: when I repeated Taylor's claim that the recent growth of the trade deficit was due to foreigners' eagerness to invest in the United States (rather than a decline in national savings) at the Berkeley Economics Department Tea, the reaction was general laughter--for Taylor's claim is false.* Not to mark it as false misleads his readers. And the article doesn't make it clear that the Greenspan-Mann scenarios require (i) continued foreign central bank purchases of dollars on a huge scale as the dollar (gradually) declines, and (ii) that private foreign exchange traders continue to fail to make large bets that the dollar will decline. We need both of those to happen to repeat what took place between the Plaza and the Louvre Accords in the mid-1980s. If we don't have both of those over the next several years, the times will be very interesting indeed on the foreign exchange market.

Take a look at the figure above. The blue line shows (gross) investment in America as a share of total GDP. The green line shows savings--household, business, and state and local government savings--as a share of GDP. The purple line subtracts the federal deficit--federal government anti-savings--from the green line. It shows national savings as a share of GDP.

The gap between the blue line and the purple line is the U.S. trade deficit. Because there is more being invested in the U.S. than Americans are saving, the difference is financed by foreigners. And to earn the dollars to finance their investments in the United States, foreigners in total have to sell us more in imports than they buy from us in exports. They take their earnings from imports, use some to finance the surplus of investment in America over American savings, and use the rest to buy exports from America.

Between 1995 and 2000 the trade deficit grew because investment rose as a share of GDP> Between 2000 and 2003 investment shrank, but the trade deficit did not fall. Instead, the trade deficit grew in spite of falling investment, in spite of rising private savings, because of the Bush budget deficit.

Posted by DeLong at November 16, 2004 10:21 AM | TrackBack

Colors/text don't match on the graph explanation.

Posted by: Nicholas Weaver at November 16, 2004 10:35 AM

Taylor's comments are false but Richard Cooper puts an interesting twist to the situation claiming the rise of U.S. dollars in the foreign portfolios represents a small part of the overall portfolio. But could not even small changes require significant repricing of assets?

Posted by: pgl at November 16, 2004 11:04 AM

The Bush administration doesn't seem to be worried about either a falling dollar or sustained deficits. If the dollar keeps falling though, which as I understand they hope will boost exports. How are foreign countries going to keep financing our debt if they can't increase their own exports to pay for it? It seems you can't have it both ways, what am I missing?

Disclaimer: I'm not a economist and I don't play one on TV.

Posted by: Sauce at November 16, 2004 11:22 AM

In the global economy, some amount of that investment is by US firms that have moved offshore for tax purposes (no longer US firms). Some of the trade imbalance is due to shipments within multinationals. This is not to dismiss the problem but the landscape has changed. We need some new metrics that incorporate the changes.

Posted by: bakho at November 16, 2004 11:30 AM

Richard Cooper would be more convincing if he could get today's current account deficit right to within $150 billion. But not much more. It is foolish to assume that ROW savings are a proxy for what might flow into the USA. At the very least, he should measure net rather than gross savings overseas. And he should also take account of the fact that the natural pace of net additions to the ROW housing and capital stocks is probably not zero. The US current account deficit is about 70% of the total surplus being run by surplus economies. It is BIG, on a global scale.

Posted by: Gerard MacDonell at November 16, 2004 11:32 AM

It seems to me that a little perspective could be gained by looking at this from the Chinese side. What they're doing is something like what the automakers have been doing--offering really great financing to their customers just to get the merchandise off the lot. They're just doing it on a national scale, keeping their currency artificially low by buying dollar-denominated securities. Sure, they'll have to stop sometime--but isn't that more their problem than ours? Won't we just stop buying so much in the way of Chinese-made goods? Are we really suckers for taking advantage of the offer while it lasts? (Of course, 0% financing wasn't enough to make me personally buy a car, so perhaps I don't really believe this line of thought :)

Posted by: Douglas Davidson at November 16, 2004 11:41 AM

Doesn't all this dicussion presuppose that the Cninese and Japanese not only will continue to be willing but also will continue to be able to finance US debt.

If China goes through major internal stresses caused, for example, by urban-rural / modernlizing-traditional tensions, then loans may cease regardless of what the Chinese government otherwise might prefer.

Posted by: Cassandra at November 16, 2004 02:26 PM

Nevermind the bollocks...

Did any one notice this editorial in the Modnay Nov 15 WSJ.,filter.economic/news_detail.asp

FINALLY! Someone has outlined the Bush Policy on current accounts. To my untrained eye this appears to be the most coherent and internally consistent statement of neo-conservative principals on the question of the Dollar. This is where the intellectual fight can get started.

For parallels search IMF Intervention, Great Britain, 1972-1974 (OK, I'm getting carried away now).

Posted by: Michael Carroll at November 16, 2004 02:27 PM

"One group, which includes the Federal Reserve chairman, Alan Greenspan, contends that global financial markets are awash in so much money that the United States can borrow much more than seemed possible 20 years ago. The dollar may well decline in value, according to this view, but the decline would be gradual..."

However an article in the Chinese press reports the Fed chairman saying that "the growing US budget deficit could destabilize the economy. . . In the last two months, Greenspan and at least seven other Fed officials have warned lawmakers about tax-and-spending policies that have led to record budget and current account gaps."

The reality seems to be that it doesn't matter what the international banking system says. National politics has the final say - isn't that why the US debt keeps on being funded by Asian banks.

Posted by: IJ at November 16, 2004 02:37 PM

The Makin article was quite good, and makes the easy-to-forget point that because of the peg China's monetary policy is determined by Greenspan . . . . . . .

If it's true that 1/2 of all Chinese bank loans are not money good, then it's at least possible that the Chinese authorities are trying to reflate their way out of a banking crisis before they revalue the RMB. We'll see.

In the meantime, the dollar goes lower and gold goes higher. FYI, UBS is rolling out a gold-backed ETF this week (StreetTRACKS Gold Trust) which allows for easy investment in gold bullion for only 40 bps in annual fees (excluding discount commissions).

Posted by: Anarchus at November 16, 2004 03:43 PM

Anyone care to guess about the consequences of the sharp rise in the Producer Price Index? More interest rate hikes for sure, yet the long Treasury note was little moved. Hmmm.

Posted by: anne at November 16, 2004 04:16 PM

"One group, which includes the Federal Reserve chairman, Alan Greenspan, contends that global financial markets are awash in so much money that the United States can borrow much more than seemed possible 20 years ago. The dollar may well decline in value, according to this view, but the decline would be gradual..."

Greenspan's views, not exactly a paragon of objectivity, carry some merit in this instance. The market is certainly awash in liquidity. The relative calm in the credit markets exemplify this point. Aside from the Fed's rampant, out-of-control credit creation, liquidity continues to grow through the financing activities of the GSEs. Fannie and Freddie can essentially be treated as money because they are financing the Fed's attempt at reflation.

There's certainly more financial "stretch" out there than 20 years ago.

Posted by: at November 16, 2004 06:43 PM

The dollar is now extremely CHEAP against its G-7 trading partners on a long-term forward basis (ie. allowing for interest rate differentials, inflation, term structure etc). However, the dollar is EXPENSIVE against two specific regions: South America and non-Japan Asia. This is where the US current account deficit is large, and currency valuations are cock-eyed. Whether SE Asia adjusts is entirely a policy choice on their part. If they choose not to revalue, then the US Current Account deficit can continue to rise without limit, and the dollar can continue to remain 'overvalued' on a trade-weighted basis, as it currently is.

Brad - your govt dissavings chart should be fully welcomed by you. If it weren't for the rising federal deficit, the recession still wouldn't be over (granted, the composition of the deficit was not optimal for the purpose of stimulus).

Posted by: Peter vM at November 17, 2004 03:39 AM

Asia has much more to lose than the US from the inevitable currency realignment. Asia will take a 20%+ hit on their trillion dollar reserves, giving US taxpayers an implicit capital gain.

US bond yields MIGHT rise as a result of an absence of Asian buyers, but probably not enough to affect real econonomic activity in the US. Because bond yields discount the future path of Fed funds, any significant rise creates arbitrage opportunities.

Posted by: Peter vM at November 17, 2004 04:00 AM

A bit of a sidelight, but did people see the WSJ article last week about the declining "agricultural trade surplus" and why that was a big part of the explanation of our worsening overall trade deficit?! This reporter - I don't remember his name - had no clue that the trade defict is a macroeconomic phenomenon, that its level cannot change unless either saving increases or investment falls. I would expect this kind of ignorance from the local fish-wrap, but the WSJ?

Posted by: kevin quinn at November 17, 2004 08:01 AM