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March 16, 2005

Buttonwood Thinks About the Dollar

From the Economist:

Economist.com | The Buttonwood column: the dollar: In two of the past three weeks, the dollar took a pasting on reports that various Asian central banks, whose purchases of America’s debt help it to go on borrowing and consuming, were planning to diversify their foreign-exchange reserves away from dollars. Bond yields spiked up....

America’s economic growth... mammoth consumption by both the private and public sectors... big trade and fiscal deficits... needs foreigners willing to suspend disbelief and buy shiploads of securities denominated in a currency that has steadily lost value for about 40 years.... Asian central banks have accumulated about $2.5 trillion in foreign-exchange reserves, up a quarter in little more than a year, most of it in dollars; Japan and China alone have reserves of nearly $1.5 trillion between them.

Central banks have more reason to purchase dollar assets than to dump them. Buying American securities keeps their own currencies low, their exports competitive and their workers free to move from fields to factories.... But the Faustian deal... whereby America gets to spend beyond its means and Asia gets to invest in export-led growth... turns out to have a shorter horizon than most people reckoned. It could turn sour at any time now. And confirmation of that comes from another set of economic data, this time due out on Wednesday: figures for America’s fourth-quarter current-account deficit. Officials have already warned that it will be a stinker....

[W]hat will happen if a significant portion of countries decided not to add to their dollar holdings? More than the dollar would weaken. Big foreign buyers of bonds have been keeping interest rates down, perhaps by one percentage point, as Alan Greenspan suggests. That would change, for a start. Without this support, the yield on the ten-year benchmark Treasury bond could rise to more than 5%, pushing up interest rates on mortgages. That, in turn, could prick America’s house-price bubble and prompt a general deleveraging, with implications for economic growth both in America and elsewhere. Standard & Poor’s, a rating agency, warned on Monday that a weak dollar would substantially increase concerns about credit quality. This is perhaps not the week to air such apocalyptic concerns, though they are much on Buttonwood’s mind. In the end, what foreign central bankers have it in their power to do is to reveal before all the world that the mighty American economic empire has no clothes...

Meanwhile, it seems as though the spring Brookings Panel on Economic Activity has four dollar papers--Mike Dooley and Peter Garber, "TBA," discussed by Barry Eichengreen and Jeffrey Frankel; Sebastian Edwards, "The U.S. Dollar and Twenty Five Years of U.S. Current Account Imbalances," discussed by Kathryn Dominguez and Pierre-Olivier Gourinchas; Olivier Blanchard and Francesco Giavazzi, "The U.S. Current Account, the Dollar, the Euro, and the Yen," discussed by Ben Bernanke and Helene Rey; and Maury Obstfeld and Ken Rogoff, "TBA," discussed by Richard Cooper and T.N. Srinivasan--and us on "Asset Returns and Economic Growth." The only one of the four dollar papers I've seen is Blanchard and Giavazzi.

Posted by DeLong at March 16, 2005 06:44 PM