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December 20, 2004

Brad Setser Tells Me What to Read

Brad Setser says I should read (a) Morgan Stanley, (b) the guy in the office immediately to the north, and (c) the about-to-be-rotated-off Buttonwood:

Brad Setser's Web Log: Plaza, or Louvre?: Two last notes. First, Morgan Stanley's year end spectacular on global rebalancing is worth reading, if only to see how Morgan Stanley's regional/ country economists reponded to Roach's demand that they lay out what their region/ country could do to support global rebalancing. The most common answer was not very much -- that lends support to Barry Eichengreen's pessimism in today's Financial Times. Second, I am going to miss this year's Buttonwood columnist in the Economist. Buttonwood's column highlighting the similarities between the US and a hedge fund was a classic. The new Buttonwood could start by highlighting the growing similarities between Asian central banks and macro hedge funds: afterall, Asian central banks are making big, and increasingly leveraged, macro bets on both the dollar and US interest rates ... Not exactly the macro bet I would want to be taking, but a macro bet all the same...

Unfortunately, the FT won't let me read Barry Eichengreen's column due to excessive server load...

Posted by DeLong at December 20, 2004 11:52 AM

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Quite off topic, but I was wondering, what has been happening behind the scenes here? I'm primarily a newsfeed reader (NetNewsWire) and the XML site information used to contain nicely formatted (not to mention full posts) however since the weekend (yesterday, I believe), XML information has come across as unformatted blocks of text, as well as not containing the full post. I was wondering if something could be done? Again, my apologies for the off topic comment.

Posted by: Greg at December 20, 2004 12:06 PM

December 20, 2004

Why the dollar's fall is not to be welcomed
By Barry Eichengreen - Financial Times

Congenital optimists see the dollar's fall as part of a necessary rebalancing of the world economy. Without a change in exchange rates, the US current account deficit is on an explosive path. It could widen from its current 5-6 per cent of US gross domestic product to 8 per cent in 2008 and 12 per cent in 2010.

In reality, deficits of this magnitude are not something that foreigners would willingly finance, especially in so far as they reflected chronic budget deficits rather than high levels of private investment. At some point foreign investors would pull the plug, and the dollar and the US economy would come crashing down. A smooth and moderate decline in the dollar that narrows the US current account now is thus preferable to a sudden and potentially catastrophic fall later.

The question is whether or not it is already too late for a smooth adjustment. The current account is the difference between savings and investment. Narrowing the US deficit will therefore require some combination of increased savings and lower investment. The falling dollar will bring this about by tending to drive interest rates up. As Asian central banks curtail their purchases of US Treasury securities and sell some of their existing holdings, there will be upward pressure on US Treasury yields.

Moreover, as the dollar falls, there will be upward pressure on US import prices and more inflationary pressure generally. In response, the Federal Reserve will have to raise interest rates faster than currently expected. Higher interest rates will make borrowing more expensive and slow investment growth. They will have a negative impact on asset valuations, including house prices. US households, no longer living off capital gains, will have to start saving again. With investment down and saving up, the current account deficit will narrow.

Unfortunately, this happy observation is not the end of the story. A significant decline in both consumption and investment will mean a recession in the US. This conclusion is so obvious that the only question is why the markets are not forecasting it already.

The answer, presumably, is that investors do not believe that the dollar's decline will produce a significant increase in inflation. The historical data say that a 10 per cent fall in the dollar produces 3 additional percentage points of inflation, which in turn implies a 450 basis-point increase in the discount rate. Clearly, we have not seen anything like this yet. Treasury inflation-protected securities spreads - the difference between yields on conventional Treasury securities and Tips - suggest only a modest increase in inflationary expectations. Maybe the 'new economy' has rendered the US economy more flexible and resilient so that the traditional relationship between dollar depreciation and inflation no longer holds. Perhaps, then, fears of significantly higher interest rates are exaggerated.

But even if this observation is correct, it just means that the dollar will have to fall further to generate enough inflationary pressure to force the Federal Reserve to raise interest rates. At the root of the dollar's decline is the view that the US current account deficit is unsustainable. Foreigners will therefore keep selling dollars until it narrows. This in turn means that the dollar will keep falling until US inflation heats up to the point where the Fed does indeed have to raise interest rates. The implication, that the US economy will slow or more likely succumb to recession, is unavoidable.

The question is whether there is anyone to take up the slack. For the world economy to avoid a serious downturn, less consumption and investment in the US will have to be offset by more consumption and investment elsewhere. But where? Europe is stagnant, and the European Central Bank has shown no awareness of the need for monetary stimulus. China is cooling off, and it will cool off more as it allows its currency to strengthen. Japan's modest recovery will disappoint now that it has to raise taxes to control its own spiralling debt. Countries outside the Group of Four nations (the US, the UK, Japan and Germany) are simply too small to make a difference.

The implication is that the correction of the US current account deficit that is now getting under way will mean a recession not just for the US but for the rest of the world. The optimists who are welcoming the dollar's fall should think again.

The writer is professor of economics and political science at the University of California, Berkeley

Posted by: anne at December 20, 2004 12:49 PM

Yes, I think things may very well end badly - a dollar collapse is not ruled out.

Yet, implied equity vols are at all time lows*, and long bonds made a pretty decent return in 2004.

Are investors taking on massive amounts of risk chasing return? Or are we macro-focused folks too pessimistic (and risk averse)?

*I've been trying to understand whether this really implies an optimistic opinion about the market, or whether there are some structural factors pushing down the implied vol. At the moment I am unsure.

Posted by: steve at December 20, 2004 02:38 PM

Dr. Delong: When the web traffic clears and you are able to read Eichengreen, you will see that Setser mischaracterizes his view. Eichengreen worries about a dollar "hard landing", which forces up interest rates and triggers a quicker rebalancing of saving and investment rates than can be accommodated via net exports, absent a reduction of national income.

I think the odds of the Eichengreen outcome are low, mainly because uncovered interest parity does not set the level of interest rates in the USA. But more to the point, the odds of a dollar hard landing would clearly be LOWERED if Asia refused to co-operate in the global rebalancing. Eichengreen as much as said so in his article.

If Asia refuses to "co-operate", then the rebalancing is not more painful. Rather, it is just slower and even less likely to be destabilizing.

So Setser's suggestion that Asia may stall is actually at odds with his endorsement of Eichengreen's hard landing scenario.

Posted by: Gerard MacDonell at December 20, 2004 03:59 PM

Buttonwood isn't being rotated off. He's gotten a job with a big bank and will be, I presume, shorting the dollar heavily. We'll miss his columns.

[O.K., who is Buttonwood?]

Posted by: Ants at December 20, 2004 11:27 PM