I have to completely agree that it is not likely that the Asian central banks would still demand USD assets if the peg were to be broken. However, I do think that EUR appreciation is at least partly determined by these Asian actions. China is undoubtedly buying some EURs. As they purchase more USD to maintain their peg, they have to sell some USD and buy some EUR just to maintain the existing proportions of EUR and USD in their reserves.

"It offers the opportunity to reduce budget deficits without triggering a recession."
I don't understand why this is so. US Gov't debts are in USD so only inflation can reduce them. A USD depreciation increases import prices, which by itself could lead to a recesssion (like the oil shocks of the 70s) if not countered by increased gov't spending. Is the idea that import price rises lead to inflation that reduces gov't deficits? It seems much more likely that the Fed will just raise interest rates and create the recession. What am I missing?

Most of our industry today exists only to collect money from the government, ie, our beloved military/industrial complex. Since we don't pay taxes for this extravaganza and since sales to foreign entities isn't nearly enough thanks to our refusal to sell to our top trader, China...ahem....means vast and yawning trade deficits.

If anyone thinks this will end with a happy story, like "and the Chinese Communist Party put a dollar under our pillow and took away the tooth we lost" then....we are going to be toothless, no? heh.

a variatiion to marku's ?

wouldn't the expected surge price of oil (denominated in $'s) cause massive economic pain since i assume that the demand for oil cannot drop that much in the short to medium term

surely stagflation or outright recession

Whether Asian central banks would actually sell dollars is debatable (more below). Whether that would need to happen for abandonment of dollar pegs to generate a violent Roubini/Setser overshoot is also debatable.

Brad is right to highlight a key feature of the BGS model: the initial large, unexpected decline in the value of the dollar leaves foreign private investors underweight in dollar assets. The result is to slow and smooth out the follow-up dollar decline.

However, were the pegs to be abandoned, foreign private investors might respond by rushing out the dollar, even if Asian central banks maintain their current dollar holdings. Fear (i.e., the desire to avoid unknowable, and potentially large further capital losses) might overwhelm portfolio balance effects. Thus a Roubini/Setser overshoot.

Would Asian central banks actually sell dollars, after leaving dollar pegs (or semi pegs)? Brad write of BGS: "The implicit assumption that Asian central banks hold on to their current holdings of dollar-denominated assets even after the reason for acquiring those assets--maintaining social peace through high exports from Shanghai--is gone."

But the goal of maintaining social peace in Shanghai remains. Even if the dollar peg is abandoned, the authorities will want to avoid moves that make the resulting decline in exports worse, e.g., dumping dollars to buy euros. Moreover, shifting into euros would tend to generate deeper capital losses on the larger, unshifted portion of the reserve portfolio.

Finally, note that diversifying the existing portfolio into euros would be equivalent to sterilized foreign exchange intervention in support of the euro; while the European authorities already regard the euro's current value as uncomfortably high. The political economy constraints on such a policy are obvious.

A last point that I think is often lost in this debate. Most authors tend to take the scale of Asian reserve accumulation as a metric for the underlying degree of balance of payments disequilibrium. But the bulk of Asian reserve purchases recycle speculative inflows into Asian currencies. With no peg to attack, those inflows would dry up. (We saw this in Japan after reserve purchases were halted last spring.) To put it another way, Asian reserve purchases don't represent an outward shift in Asia's demand for dollar assets. Rather, they are (mainly) an attempt to offset a speculative run out of dollar assets by private investors.

A better metric for balance of payments equilbrium might be a balanced current account or a current account deficit equal to FDI inflows (basic balance). This implies, in China, a negative shift in the current account of 1/4 to 1/2 the scale of recent reserve accumulation.

What is the Global Stagflation Terror Weapon...

It is also called "Chicken." We get to inflate away our debts AND scare the Asian central banks and OPEC with the threat of a global recession. Seems like of all the major economies the U.S. is by far in the best place to whether a period of Stagflation or global recession. The march of progress may take a ten year detour as a result but at the end of that period the U.S. will still be in front and that sits pretty well with some of this Countries geopolitical strategists in my view.

The cards suck but the U.S. holds the best ones as evinced by the way the Korean Central Bankers got pounced on for getting chippy last week.

Of course the real lesson for the rest of the world is: don't play poker with cheaters, or better yet don't play poker at all.

Were the dollar to fall sharply, there would be a demand increase for domestic goods. After all, domestic goods would be relatively less expensive. An increase in domestic demand would spur economic growth, and there would be an opportunity to trim the budget deficit without necessarily causing a recession.

What Japan and Europe might do however to stimulate growth should exports sharply decline is less clear. Japan already has interest rates that are extremely low and a large government deficit. The European Union has somewhat more room for interest rate decreases or for a fiscal stimulus, but not that much more room.

Brad Delong:

[I]n BGS the collapse of the peg is unexpected. The decline in the value of the dollar carries with it a huge decline in the foreign-currency value of dollar-denominated assets with no compensating increase in contemporaneous returns or fall in desired dollar-denominated asset holdings valued in foreign currency.

Why should this be so? Why would a sharp decline in the value of the dollar not immediately make American assets more valuable internationally? Hmmm.

> M. Obstfeld and K. Rogoff (2004),
> "The Unsustainable U.C. Current Account
> Revisited" (Cambridge: NBER).

I have no doubt the U.C. current account position is unsustainable: probably all those slush-fund research accounts.

[LOL]

What am I missing? Why would a sharp decline in the value of the dollar not immediately make American assets more valuable internationally?

Brad, it's a great paper - but most non-academics will not have access to NBER discussion papers without paying $5.

However you can download it free from SSRN:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=655402

I've also posted on this topic recently, here:
http://neweconomist.blogs.com/new_economist/2005/02/should_we_worry.html

anne –

It is unlikely that U.S.-produced goods could substitute for Asia-produced goods in any meaningful time frame. To paraphrase the Secretary of Defense, import substitution would have to be done with the productive capital we have, not with the productive capital we wished we had. As David Hale argued in a Financial Times op-ed a few months back, current U.S. capacity utilization rates leave little spare capacity for the manufacture of substitutes for higher-priced Asian imports. Given the lamentable lack of U.S. public or private savings, U.S manufacturers would probably have to finance any expansions of their productive capacity out of their own pockets. I doubt they will feel comfortable making such commitments.

As for you inquiry regarding the "The decline in the value of the dollar ...valued in foreign currency." sentence, I wonder if Dr. DeLong, typing in haste, got his denominations and values mixed up.

If you have not read it already, Gourinchas & Rey's paper "International Financial Adjustment" is available in pdf at:

http://ist-socrates.berkeley.edu/~pog/academic/IFA/ifa.pdf

I am not quite sure I buy the assertion that they have found a drastically better method of predicting currency movements in the 1-month to 6-month window. However, I think they make a valuable contribution to the discussion over the value of the dollar in noting that, after a depreciation, adjustments in the current account deficit initially come through investment returns from FDI, not from increased exports.

MTC

Finished an initial reading of the paper. You are right in summary :) This passage though stills puzzles me, but I am tired and need to escape from currency land and play with a chirpy conure for a while. I agree with you, as usual.

"The decline in the value of the dollar carries with it a huge decline in the foreign-currency value of dollar-denominated assets with no compensating increase in contemporaneous returns or fall in desired dollar-denominated asset holdings valued in foreign currency."

Asian (and other) Central Banks need to retain considerable US$ holdings to pay for oil imports. If the price of oil rises, these holdings must also rise. To what extent does this impose a floor under the US$ holdings of Central Banks, preventing sudden large-scale sell-offs?

anne, IANAE, but I'll take a stab at it...

Isn't he just saying that a foreign holder of a US asset will see the value of that asset decline after the dollar falls?

He's not talking about someone holding euros seeing US assets become attractive after the devaluation, he's talking about folks in the EU who were holding US assets when the dollar fell.

Again, IANAE, and it's late, so I may be completely misguided or delusional.

I'm going to have to keep asking this question.
To _whom_ are the Asian banks going to sell the dollars, and in exchange for what?

Since Americans don't have anything except dollars to buy with, the Asians can't reduce their dollar reserves by selling their Treasury securities to Americans. Are Europeans going to take the dollars in exchange for Euros in any quantity large enough to make a difference?

The Japanese and Chinese governing elites have both distorted their economic systems so severely that their only alternative to running immense trade surpluses is severe social dislocation and possible complete loss of power. They won't allow this. It doesn't matter to them that it's bad business -- it's not their money.

jm -

The Japanese fiscal year ends March 31. It will be difficult for the MOF and the BOJ to intimidate Japanese private entities into keeping their profits outside the country in dollar-denominated assets (the MOF's power of intimidation has diminished since its inspections functions were hived off to create the Financial Services Agency). If these assets are sold, they will of course be sold to Americans for dollars. The dollars will then have to be converted into yen at market rates. With only 17% of Japan's GDP locked up in dollar reserves (compared to 30% of GDP in China and 96% in Singapore), the MOF and the BOJ in theory have some ammunition left for currency intervention. However, the MOF and the BOJ are probably looking back and forth between the potential capital loss following a dollar devaluation, Japan's trade surplus with the United States and Japan's GDP growth rate and are figuring that the jig is just about up.

Brad DeLong

"The decline in the value of the dollar carries with it a huge decline in the foreign-currency value of dollar-denominated assets with no compensating increase in contemporaneous returns or fall in desired dollar-denominated asset holdings valued in foreign currency."

Then, a dramatic decline in the value of the dollar would not have allowed for an increase in returns from dollar assets for international investors. An international investor is simply left with assets that are worth less than before the devaluation in Euros or Yen. Ah...

Both scenarios look somehow unconvincing. Will the Chinese (and Japanese) central bank just wait till the peg cracks, Soros style, and then let the currencies float to whatever level?

The much more plausible scenario is that when they consider the situation unsustainable, they would shift the peg in a one-time fashion to a higher level, levelling the tension. A complete sell-off seems implausible.

JM, I went into this issue in some detail back in November, here. I call it the Richard Whitney scenario, for reasons that should be clear in the post. Basically, there's a risk that, if the ECB starts intervening to keep down the euro/dollar rate, they will end up being unloaded on by everyone else. Rather like Mr. Whitney supporting the shares of his company, they will spend a lot of money letting the Asian central banks get out.

MTC writes, "If these assets are sold, they will of course be sold to Americans for dollars. The dollars will then have to be converted into yen at market rates." But because decades of mercantilism have ensured that (for all practical purposes) no one can get yen by exporting to Japan, the only way to convert dollars into yen is to sell them to another Japanese entity (e.g., the government). So there would be no net reduction in Japanese holdings of dollars, and if the trades were only among private entities the effect would be that the yen value of all those bonds the insurance companies bought to get the 300 bp spread would plummet in value. Considering the weaknesses of the Japanese financial system, the amount the dollar would need to fall to make it attractive (absent a BOJ value guarantee), and the fact that there are now more mark-to-market requirements for assets, is the Japanese government going to allow that to happen?

Until Japan allows the dollar to fall to a level at which money can be made exporting goods and services from to it from the US (or from somewhere else that has a trade deficit with the US), Japanese dollar holdings can't fall -- they can only move from the hands of one Japanese entity to another, at whatever exchange rate the Japanese decide on among themselves*. While they certainly ought to let that rate fall, will they? A lot of birds would come home to roost, and they wouldn't be chickens.

*(Unless the ECB decides to step in and support the dollar by buying up dollars with printed Euros.)

Thinking about my statement above that, "A lot of birds would come home to roost, and they wouldn't be chickens," I see that it doesn't express what I really believe. In fact, allowing the yen to rise enough to induce a trade deficit is exactly what the Japanese bureaucrats should do -- if done with some safety net measures to smooth the transition, it would set the economy free and soon have wonderful effects.

But if the Japanese power elite had surrendered in WWII at that point where the complete bankruptcy of their policies was utterly obvious, all the destruction of the 1945 bombing could have been avoided. They didn't. The people and organizations running the show now are their lineal descendants. I suspect that they again will not change their ways until they have brought the nation to the very brink of disaster.

Amending again: Since Feb. '45 was the brink of disaster, and Aug. '45 far, far over the brink, I should have written, "... to the depths of disaster."

Comment from the peanut gallery. It's been years since I studied economics. Great website by the way.
Very interesting topic. So... we save very little and our Government spends a lot and other countries export everything to us. This does not seem to cause an imbalance because the other countries will not let the exchange rate adjust so that eventualy our imports drop and our exports increase. What an odd set of circumstances. Is this because we're the most powerful nation and we force trade on others and they can't do anything about it? Or is the trade deficit tiny compared to the size of our GNP?

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