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January 11, 2005

The Strong Dollar Policy

Brad Setser writes about the Bush administration's strong dollar policy:

Brad Setser's Web Log: Not where we should want to be: It is not a good sign when market strategists say any mention of "fundamentals" is dollar negative.... "'Snow qualified the US's ongoing "strong dollar" policy by pointing out the importance of fundamentals, which underscores the US's glaring double deficits,' said Hans Redeker, global head of FX strategy at BNP Paribas." Ouch.

Maybe Snow's statement is a step toward replacing the "strong dollar" rhetoric with Morris Goldstein's suggested new rhetoric of "a dollar that is consistent with sound economic fundamentals at home and abroad." In other words, a weak dollar.

Indeed, if the dollar's value truly was set in the markets, it would have fallen much more than it already has. We now know Asian countries spent almost $530 billion propping up the dollar in 2004. $530 billion! The sums are staggering: Japan, almost $180 billion; China, $200 billion, other emerging Asian economies, another $150 billion...

What continues to dumbfound me about the situation is that $530 billion worth of purchases of dollar-denominated securities in 2004 was enough. Foreign private investors currently hold perhaps $700 billion of Treasury securities, perhaps $2.5 trillion of other dollar denominated securities, and are owed perhaps $1.4 trillion by U.S. banks. All these securities are liquid. Why--given the likelihood of further dollar declines, and given the absence of any compensating interest rate premium on dollar-denominated assets--haven't the holders of these securities tried to dump them?

I know that I'm a dissenter from the efficient markets hypothesis, and a believer in behavioral finance, et cetera. But this is ridiculous.

Posted by DeLong at January 11, 2005 10:05 PM

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Comments

I once saw a documentary from 1988 (http://tinyurl.com/6wwjg) that said it was because the Aliens from Andromeda have printed subliminal messages underneath our money, "THIS IS YOUR GOD". And things like that.

I'm glad to hear you dissent from the efficient markets hypothesis. During the height of the bubble, I was at Haas listening to the professors there tell me there was no such thing as short term speculators and that if they did exist they could have no effect on the pricing. Then two years after I graduated these same "professors" were selling a $2000 seminar to their recent alum explaining all about their new fangled behavior finance theories.

This let me know that the warranty on a Haas MBA was definitely less than two years.

Posted by: jerry at January 11, 2005 10:42 PM


Brad Delong asks: "Why--given the likelihood of further dollar declines, and given the absence of any compensating interest rate premium on dollar-denominated assets--haven't the holders of these securities tried to dump them?"

My answer: economic suicide.

Some small countries have already started moving from the dollar to the Euro. From this article "Saudi central bank chief sees greater role for euro":
http://www.gulf-daily-news.com/Story.asp?Article=101149&Sn=BUSI&IssueID=27298

"Data from the International Monetary Fund showed the euro's share in official FX reserves rose to 19.7 per cent in 2003, up from 13.5pc in 1999. The dollar was still dominant, with its share standing at 63.8pc compared with 64.9pc. ... there are signs oil producers are shifting their dollar-denominated deposits, mainly to the euro's advantage."

But if countries like China, Japan or other Asian countries even stopped buying dollars, much less sold their holdings, the US interest rates would rise dramatically, probably leading to a global recession and unacceptably high unemployment for these exporting nations.

As Economist Herb Stein so astutely noted: "If something cannot go on forever, it will stop."

My question is: When will it stop?

Posted by: CalculatedRisk at January 11, 2005 11:04 PM


Brad, I think the answer is that in the case of Japan and China the purchases of US dollars and securities are only a consequence of domestic economic considerations, rather than an end in themselves. In both cases these countries are suppressing appreciation pressure on their currencies against the major currency their trade is denominated in i.e. the US dollar. Both the BoJ and SAFE are not stupid. They realise they're on a merry-go-round of their own making. But halting these purchases will result in currency appreciation that neither are prepared to put up with at this stage.

I have a feeling there is an element of "let's hope the Americans sort out their savings imbalance" to get the Asian central banks out of their pickle. But the size of their holdings make it a matter of years to reverse the current situation. What's most ironic is at least in China's case for much of its currency history the pressure was to devalue rather than revalue. Do Communist Central Bankers know how to get out of this free-market problem? We're going to find out.

Posted by: Simon at January 11, 2005 11:26 PM


Everyone seems to be convinced that the Asian Central Banks will not allow the dollar to go down too far.

Posted by: Walker at January 11, 2005 11:56 PM


They're playing a long game. Although the value of dollars is likely to fall in terms of the yuan goods and services they will buy, the amount of American assets they will buy isn't likely to go anywhere; the USD is still a hard currency in inflation terms.

And, the simple fact is that you can't spend $200bn on Chinese capital assets, because there isn't $200bn of Chinese assets to buy.

At the hypothetical future date at which China gets itself into a position where it wants to reverse its big net creditor position with respect to the USA, there's no telling what the USD rate will be.

Posted by: dsquared at January 12, 2005 12:00 AM


Bubbles usually are ridiculous, no?

Posted by: Randolph Fritz at January 12, 2005 12:31 AM


Brad,

YOu say... "Why--given the likelihood of further dollar declines...." I like the word you used LIKELYHOOD.

Dollar decline is not a sure event, it seems. I was watching rupee vs dollar. Dollar is bouncing back to level where it was 3 months ago.

I think this fluctuation is causing the asian central banks to not take any major decisions. Infact nobody is taking any major decisions.. the banks keep buying dollars, Bush and co are sleeping, we keep discussing. Nothing has changed ??

Posted by: navin at January 12, 2005 01:30 AM


There is little inflation in America relative to Europe, so even if the dollar is likely to decline in value against the Euro there will still be United States assets to be purchased at a reasonably constant dollar value. So, dollars are held by private investors but they can not be help with any confidence as to exchange value. My Asian friends are content to hold dollar assets simply to diversify, though they believe the dollar will lose value relative to many Asian currencies. These friends however are not planning to add dollar holdings readily. How long, how long?

Posted by: anne at January 12, 2005 03:04 AM


Since there is no reason to believe America will reduce its domestic or foreign debt, or even much limit the growth of debt, we can only assume there will be increased pressure on the dollar this year though the Fed will be raising short term interest rates. The questions are how long this dollar pressure can remain orderly, and what international assets Americans should hold?

Posted by: anne at January 12, 2005 03:21 AM


That rote question at this point is "So you've mortgaged your house to short the dollar?" Even if you don't like the efficient markets hype, there is still a grain of truth to the assertion that the best forecast of tomorrow's fx rate is today rate. If odds of further dollar losses were truly, objectively high, then people would be selling dollars in great enough amounts to change the value of the dollar today. The magnitudes you offer show that central bank purchases in 2004 amounted to 10% of all foreign holdings. They financed just about the entire US current account obligation last year. There is tremendous turn-over in fx markets, vastly oustripping net changes in holdings, so that an increase in foreign holdings of dollars can accompany a drop in the dollar's value, but...it would be a heck of a thing for investors to fully offset central bank purchases. If memory serves, TICs data from recent months show that private investors have once again become bigger buyers of US assets than are central banks.

Posted by: kharris at January 12, 2005 04:41 AM


The real explanations must be that the current situation is confortable for all parties involved (Asia has the jobs it wants, the US the cheap financing it needs). On the other hand, leaving behing this "new Bretton Woods" would involve very large and painfull adjustements to all involved. A recent paper by one of the local Fed offices showed that even smal (5-10%) revalution of Asian currencies would cause HUGE looses in local currency terms. Add to this the lost jobs, etc, etc. In the end, all parties involved will not do anything until absolutely force to...

Posted by: tvolpon at January 12, 2005 05:08 AM


A long run factor is that Asia will be in good shape to buy into the next big technology developed by America. They will be able to ride the wave instead of trying to make up for lost ground after the wave has passed.

They are also poised to have their citizens take advantage of the excellent American University system. The current administration has depressed the numbers of foreign students in the US, but they should be pressured to change.

Posted by: bakho at January 12, 2005 05:56 AM


KHarris

This is a time when I am puzzled by your analysis. Speculating against a change in dollar value is different than preferring patient holdings of European or Australian or Canadian assets these last 2 or 3 years. I can not imagine the dollar holding indefinitely at current levels unless we change our fiscal mix and that is not going to happen soon. Holding European value stocks has made perfect sense as a dollar hedge and for fine investments per se. What am I not understanding?

Posted by: anne at January 12, 2005 05:58 AM


If they try to sell them, who will buy?

Posted by: eric bloodaxe at January 12, 2005 06:39 AM


Anne,

I agree, not indefinitely. After seeing the November trade account data today, the problem seems to be growing fast. However I think one of Keynes less famous famous quotes (which I can't find) is applicable. It has to do with the ability of the market to be wrong longer than the investor can remain solvent. In the short and medium term, the best forecast of tomorrow's fx rate remains today's rate. FX forecasting is notoriously difficult because the things that obviously should dictate fx rates don't do a very good job in the short to medium term. Investors who hold dollars despite a large current account deficit and a rotten US fiscal outlook are not nuts. Large current account deficits and rotten fiscal forecasts have little near term predictive value (though they make explaining fx moves after the fact pretty easy).

If central banks are willing to acquire assets in the amount of 10% of foreign held US securities, there is a powerful bias against rapid loss of value in the dollar. Ten percent is a really big number, in this context.

I am quite worried that correcting the US current account gap will be really painful. The US trade deficit is structural. The Chinese and Japanese and Korean surpluses with the US are structural. When Treasury Secretary Snow calls for more rapid growth among our trade partners to cure the trade gap, he fails to mention that more rapid growth in countries running structural surpluses with the US will have a smaller impact than when the US, with its structural tendency toward deficits, grows faster. Bringing the rest of the world up to US-style growth won't be enough. Bringing the US federal fiscal balance obviously wasn't enough in the Clinton years. The last time there was an extended improvement in the US trade balance was 2001, when imports fell by 17% (December to December) and exports fell by 16%. That's not the way we want to solve the problem, but there is little hope, I think, to solve the deficit through growth alone. Growth entails rapidly rising US imports, less rapidly rising foreign imports - things get worse, not better.

Posted by: kharris at January 12, 2005 07:15 AM


Everyone's looking at China, and China is looking at what the U.S. does for her, such as bringing the Iraqi oil to market. To buy it will cost dollars, of which they have plenty.

Posted by: Lee A. Arnold at January 12, 2005 07:19 AM


Wow, that was clumsy. What I should have written was "Balancing the federal budget obviously wasn't enough in the Clinton years."

Posted by: kharris at January 12, 2005 07:26 AM


KHarris

There is never the least clumsiness in your writing. The clarity of the writing is wonderful, and makes the writing instructive and interesting on its face.

I agree with your analysis completely, though I wish I did not for I find myself increasingly worrying. Household saving is astonishingly small, we have a government deficit that will have to grow unless there are structural changes to generate more tax revenue. Only corporate saving is ample, and we would prefer such saving be invested. Domestic debt must be reflected by balances of payments debt, future American earnings are increasingly owed abroad, so we are slowly weakening ourselves economically.

Though I have no guess on the relative value of the dollar, I am sure we are weakening economically and I worry.

Posted by: anne at January 12, 2005 07:55 AM


"In the short and medium term, the best forecast of tomorrow's fx rate remains today's rate."

This reflects the infrquency of large market swings, of course. And “Markets can remain irrational longer than you can remain solvent.” (I wonder what the context was, or even if Keynes really said it.) Yet...

"I am quite worried that correcting the US current account gap will be really painful."

Involving, say, another drop of US labor rates closer to world levels? We agree--I think most economically literate people agree--that a shift is coming. The question is how to prepare.

Posted by: Randolph Fritz at January 12, 2005 08:00 AM


http://www.nytimes.com/2005/01/12/business/12cnd-trade.html?hp&ex=1105592400&en=b324eb4a4227918c&ei=5094&partner=homepage

U.S. Trade Deficit Hit Highest Figure Ever in November
By JOHN O'NEIL

The trade deficit jumped sharply in November, rising to $60.3 billion, increasing by 7 percent over the month before.

Posted by: anne at January 12, 2005 08:09 AM


http://www.nytimes.com/2005/01/12/business/worldbusiness/12trade.html

China's Trade Surplus May Stir Currency Debate
By KEITH BRADSHER and ELIZABETH BECKER

HONG KONG - China reported on Tuesday that its trade surplus grew for the seventh consecutive month, to a record $11.1 billion in December. The surplus helped send China's foreign currency reserves soaring further, lifting the economy to another year of extremely strong growth, Chinese officials announced.

The robust performance, however, is a double-edged sword for China. It is likely to increase pressure for Beijing to allow China's currency, the yuan, to rise in value against the dollar as foreign investment and export earnings alike pour into the country at an accelerating pace. China's ballooning surplus also serves as a convenient backdrop for an increasingly polarized debate in the United States over whether trade with China is good or bad for the economy.

Posted by: anne at January 12, 2005 08:27 AM


KHarris,

I like your analysis very much.

Change to a different point: people talks about China, Japen, Taiwan, Korea as if they are a single entity, but they are not. While it may make sense for Asian central banks to buy dollar collectively, it does not necessarily make sense for an individual country to do so. For this reason, I am very puzzled why, say, China has not started selling dollars and buying Japenses yen in a large scale. What stops them?

Posted by: pat at January 12, 2005 08:47 AM


What stops China from selling dollars is the currency peg to the dollar and the wish to hold the peg. China is just not prepared to have a dramatic rise in the Yaun suddenly pressure the export market. Remember, China has 1.3 billion people and is attempting to employ vast numbers of increasingly unnecessay rural men and women in urban production. Losing any part of the export market could threaten development for a time. Accumulating dollars is a problem, but less of a problem than a production decline.

Posted by: anne at January 12, 2005 08:56 AM


My understanding is that these assets are primarily held by central banks, rather than by individual/private investors, who are motivated by political, not profit, considerations. They want to prop up the dollar so the US economy doesn't go south, so US consumers continue to buy vast quantities of Asian-made goods at Wal-Mart, thus allowing huge numbers of Asians to stay employed. If they pull out, they end up wrecking their own economies. What I keep wondering is what will happen if Bush is able to push through his insane Social Security plan, which calls for additional borrowing at a stupendous level. Would that finally convince the Asians that the US has gone completely mad, and that they need to pull out of their dollar investments, even at the cost of massive pain to their own economies? I'd like to hear from some economists on this question; it seems to me that's yet another major risk of messing with Social Security, but it doesn't seem to be getting any play in the media.

Posted by: Rebecca Allen, PhD at January 12, 2005 09:27 AM


What happened to Japan with the Plaza Accord in 1985? Suddenly the Yen was appreciating in dramatic fashion against the dollar. Was Japan simply unable to generate enough domestic consumption to continue to grow at a rapid rate after the Yen had appreciated so markedly from 1985 on? Would the Plaza Accord undermine Japanese growth? The Chinese leadership may fear not being able to turn to domestic consumption as readily as might be necessary were the currency to sharply increase in value. Did Japan fair poorly because of the Plaza Accord?

Posted by: anne at January 12, 2005 10:03 AM


I read over and over that a large current account deficit leads to a depreciated dollars and higher interest rates. But how? Any good websites to learn about this? I know nothing about international economics.

Posted by: JRossi at January 12, 2005 11:09 AM


The more the trade deficit, the more capital must be imported to pay for the deficit. There will be a time when interest rates must rise to attract the capital to support a growing trade deficit. Also, as the deficit grows the dollar may lose value in relation to other currencies. The Japanese sell us more than they buy from us; the more than imbalance the more the Japanese are asked to hold dollars so the dollar may grow cheaper relative to the Yen.

Posted by: anne at January 12, 2005 11:27 AM


"What I keep wondering is what will happen if Bush is able to push through his insane Social Security plan, which calls for additional borrowing at a stupendous level. ...it seems to me that's yet another major risk of messing with Social Security, but it doesn't seem to be getting any play in the media."

I'm not even an economist and it's occurred to me. Another indication of the provincialism of US journalists...and maybe economists, too?

Posted by: sm at January 12, 2005 11:51 AM


anne asks: Did Japan fair poorly because of the Plaza Accord?

Many people in Asia think so. They think US forced Japan to bear most of the cost of the then US current account deficit adjustment through the Plaza Accord (Andy Xie in Morgan Stanley has written quite a bit about it). I am not convinced. Nevertheless, I think this line of thinking may contribute to China's unwillingness to appreciate its currency.

As to my earlier question, why cannot China sell dollar and buy yen while keeping its own yuan peg to the dollar? I understand China wants to keep the currency peg. But some people suggest that China can still sell dollar and buy yen, thus push the appreciation pressure to yen away from yuan. My question is, is there anything missing in this logic?

Posted by: pat at January 12, 2005 11:51 AM


Suppose the Chinese switched from a dollar peg to a Yen peg. The dollar declines sharply in value relative to the Yuan. Either the price of Chinese exports increases or China has to lower production costs to keep market share. Losing exports means losing jobs, while lowering production costs means further limiting wages. Not a pleasing picture. China can try to stimulate domestic consumption, but that will take time.

Thank you, Pat.

Posted by: anne at January 12, 2005 12:13 PM


re: "the more the trade deficit, the more capital must be imported."

Or vice versa. Developing countries can have bursts of capital investment that lead to trade deficits. Investors send capital, the capital is turned into investments in factories, components, raw materials and whatever which are imported, leading to a trade deficit. Eventually, the factories start to produce and the trade deficits reverse.

I've heard it argued by Republicans, Dollar bulls, and wild-eyed optimists that this is exactly what is happening in the US right now. The American economy is so fraught with opportunity that foreigners are quite rationally investing here. In the late 90's, it might have been true (if you consider, say, Global Crossing bonds and AOL stock to be rational investments). The argument is kind of a stretch now when the capital inflow is going into US Treasuries and mortgage debt and the goods being imported are DVDs rather than capital equipment.

Posted by: msullivan at January 12, 2005 12:14 PM


The low level of credit spreads also strikes me as really odd given the potential for a rapid rise in U.S. interest rates. Check out Bill Gross' graph on the Pimco site to see them. Hard to see foreign central banks as the sole cause of the apparant optimistic view in debt markets.

Posted by: Michael at January 12, 2005 02:05 PM


msullivan,

The argument that investment is driving the current account deficit is valid, to a point. In a simple accounting sense, if there were less spending on investment in the US, the savings rate would be higher, and the trade deficit lower. That said, it is entirely possible for the current account to be driven by things other than foreign demand for US assets. Things like US demand for foreign goods (them DVDs), payments on foriegn held assets and such. Greenspan once told a congressman that a simple way to judged whether US demand for foreign goods or foreign demand for US assets was driving the current account was driving the current account was to watch the dollar. When the dollar is falling, foreigners are not sucking up dollars to buy US assets. US consumers are sucking up other currencies (indirectly) to buy foreign goods. The dollar has now been falling for 3 years - just about the time that Bush has had serious influence over the federal budget.

Posted by: kharris at January 12, 2005 02:08 PM


Dr. Delong:

Do a cash out refi on your house, lock in for 30 years, and place proceeds into Asian long-maturity debt. This leaves short the dollar far forward, which is what you view as the no brainer. Do well by doing good. Be the global rebalancing.

Posted by: Gerard MacDonell at January 12, 2005 02:46 PM


KHarris

" Greenspan once told a congressman that a simple way to judge whether US demand for foreign goods or foreign demand for US assets was driving the current account was driving the current account was to watch the dollar."

Agreed. Nicely done. We are driving the current account deficit.

Posted by: anne at January 12, 2005 03:28 PM


JOHN MAYNARD KEYNES: "Markets can remain irrational longer than you can remain solvent."

Posted by: Kosh at January 12, 2005 04:14 PM


"The robust performance, however, is a double-edged sword for China. It is likely to increase pressure for Beijing to allow China's currency, the yuan, to rise in value against the dollar as foreign investment and export earnings alike pour into the country at an accelerating pace."

Why does the NY Times print pablum like this as though it's useful? Yeah, sure, the US govt will huff and puff to China about this. And in response the Chinese govt will do exactly what they want to do, no more, no less. Being polite and not interested in gratuitously irritating anyone, they might even emit some kind words along the lines of "We are sympathetic to the concerns of the US" rather than "Screw you". But nothing important will change. Exactly what mighty pressure is the US govt poised to apply to China?

Posted by: Maynard Handley at January 12, 2005 06:21 PM


The Keynes quote is apocryphal. He said a lot of things about financial markets, and would probably have agreed if you had said that to him, but I've looked pretty hard and come up a blank trying to find any evidence of him ever having said "the market can remain irrational longer than you can remain solvent".

Posted by: dsquared at January 13, 2005 05:28 AM


Almost every reference to the "longer than you can remain solvent" quote calls it a quip, suggesting he said it, but didn't write it down. There is, however, one citation I have found, but cannot verify just now, which offers hope. A query site at HES – History of Economics Societies, offered this:

Collected Writings, XXVIII, p. 117.

[Really! Off to the library...]

Posted by: kharris at January 13, 2005 06:29 AM


I have a question about China's yuan peg. Why isn't this an unfair trading practice with the WTO? It seems in practice to be a huge subsidy for Chinese manufacturing. Direct subsidies would be unfair under WTO rules, I think.

Posted by: camille roy at January 14, 2005 10:17 AM


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