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December 06, 2004
The Future of the Dollar
Brad Setser says we should all go read the Economist on the dollar:
Economist.com | The future of the dollar: over the next few years it seems an excellent bet that there will be a large drop in the dollar. Since mid-October the dollar has fallen by around 7% against the other main currencies, hitting a new all-time low against the euro and a five-year low against the yen. The dollar has lost a total of 35% against the euro since early 2002; but it has fallen by a more modest 17% against a broad basket of currencies....
Markets have been rattled by concerns that foreign central banks might reduce their holdings of American Treasury bonds. Last week, officials at the central banks of both Russia and Indonesia said that their banks were considering reducing the share of dollars in their reserves. Even more alarming were reports that China's central bank, the second-biggest holder (after Japan) of foreign-exchange reserves, may have trimmed its purchases of American Treasury bonds... might the dollar lose its reserve-currency status? Over the past 2,000 years, the leading international currency has changed many times, from the Roman denarius via the Byzantine solidus to the Dutch guilder and then to sterling. The dollar has been the dominant reserve currency for more than 60 years, delivering big economic benefits for America, which can pay for imports and borrow in domestic currency and at low interest costs.... The requirements of a reserve currency are a large economy, open and deep financial markets, low inflation and confidence in the value of the currency. At current exchange rates the euro area's economy is not that much smaller than America's; the euro area is also the world's biggest exporter; and since the creation of the single currency, European financial markets have become deeper and more liquid....
Those bearish on the dollar are asking why investors will want to hold the assets of a country that has, by its own actions, jeopardised its reserve-currency position. And, they point out, without the intervention of central banks, which have been huge net buyers of dollars, the dollar would already be lower. If those same central banks were to begin to sell some of their $2.3 trillion dollar assets, then there would be a risk of a collapse in the dollar....
The [trade] deficit is at the heart of this issue. Various economists have put forward at least four arguments why the deficit does not matter and the dollar's reserve status is safe. First, the deficit is a sign of America's economic might, not a symptom of weakness. Second, sluggish demand overseas is a big cause of the deficit, so it is reversible. Third, the deficit exists largely because of multinationals' overseas subsidiaries. And fourth, central-bank demand for dollars creates, in effect, a stable economic system. It is not difficult to demolish each argument in turn....
Worse still, in recent years capital inflows into America have been financing not productive investment (which would boost future income) but a consumer-spending binge and a growing budget deficit. A current-account deficit that reflects a lack of saving is hardly a sign of strength....
For almost two decades, economists have worried about America's current-account deficit and predicted a plunge in the dollar and a hard landing for the economy. The dollar did indeed fall sharply in the late 1980s, but with few ill effects on the economy. So why worry more now? One good reason is that the current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s, and on current policies it will keep widening. Second, in the 1980s America was still a net foreign creditor. Today it has net foreign liabilities and these are expected to reach $3.3 trillion, or 28% of GDP, by the end of 2004 (see chart 2)....
America has enjoyed another huge advantage in its ability to borrow in its own currency. A normal debtor country, such as Argentina, has to borrow in foreign currency, so while a devaluation will help to reduce its trade deficit, it will also increase the local currency value of its debt. In contrast, foreign creditors carry the currency risk on America's $11 trillion-worth of gross liabilities....
In any case, the current-account deficit cannot be corrected by a fall in the dollar alone: domestic saving also needs to rise. The best way would be for the government to cut its budget deficit.... Sterling maintained a central international role for at least half a century after America's GDP overtook Britain's at the end of the 19th century. But it did eventually lose that status. If America continues on its current profligate path, the dollar is likely to suffer a similar fate.... if America continues to show such neglect of its own currency, then a fast-falling dollar and rising American interest rates would result. It will be how far and how fast the dollar falls that determines the future for America's economy and the world's. Not even Mr Greenspan can forecast that.
Posted by DeLong at December 6, 2004 03:25 PM
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» Dollar Diving? from Winds of Change.NET
Brad DeLong thinks the U.S. Dollar is due for a big dive. The Economist is wondering, too, esp. in light of U.S. trade & current account dseficits. Arnold Kling adds some useful thoughts on trade deficits as savings deficits. [Read More]
Tracked on December 7, 2004 11:42 PM
Comments
The reason for the support of the dollar is not economic, it is political and geostrategic, and it may remain so for a while. We are doing the dirty work to secure the third of the world oil supply under Iraq. In free markets that will flow to Asia as well. Why should they rock the boat, when they also end up with a huge bonus card to play some day?
Posted by: Lee A. Arnold at December 6, 2004 06:19 PM
Anne, Elaine, where are you? Seems everyone can see the problem, is there anyone who can see the answer?
Posted by: big al at December 6, 2004 06:43 PM
Combine the Economist article with this excerpt from Reuters: 'The president's economic advisers have been analyzing financing options for more than a year. Until now, the White House has stopped short of saying that borrowing would be needed to cover the transition costs.
Experts say Bush has few other options because of record federal budget deficits. Bush opposes raising taxes or making changes for those at or near retirement, the White House says.
"There will be some upfront transition financing that will be needed to move toward a better system that will allow younger workers to invest a small portion of their own money into personal savings accounts," McClellan said.
The transition costs will be between $1 trillion to $2 trillion, according to congressional and private-sector estimates. Asked if the costs would be financed by government borrowing, he added: "That's what you're looking at doing as part of the transition to a better Social Security system." He declined to say how much borrowing would be needed.
Bush's economic advisers believe a short-term increase in borrowing is economically feasible, and that the cost of doing nothing would be far greater in the long run. While the nation's debt load would increase initially, it would fall as the reforms are phased in, advocates say.'.
I think the Bush administration is going to do as good a job with our economy in its second term as they've done with the war in Iraq in their first term. Heaven help us.
Posted by: Jim S at December 6, 2004 06:54 PM
One of the figures in the excellent Economist article shows the behavior of the Yen and Mark against the dollar over the last 40 years, during which time they appreciated by 300%.
I think if China continues to develop we can expect the same for the renminbi vs dollar.
There is also an interesting point about net payments of interest. The US, although a debtor, has enjoyed net positive payments from abroad, since US investments abroad have performed better than foreign investments here! This is about to reverse under the weight of the huge imbalance.
http://infoproc.blogspot.com/#110227731608095310
Posted by: steve at December 6, 2004 08:51 PM
this article is highly misleading along a number of dimensions:
(1) cutting the US budget deficit will exacerbate the USD decline, not mitigate it. During 1991-95 we budget cuts leading to lower real interest rates and a depreciating exchange rate in Canada, Italy, Scandinavia, Britain and the USA.
(2) It takes 50 years for a currency to lose Reserve Status - for Britain it took from 1914-1950 to be overtaken by the dollar, and until 1977 to be overtaken by the German Deutschemark.
(3) The benefit to the US of having Reserve Status is trivially small as a percent of US GDP - both in terms of Seigniorage income and in terms of lower bond yields. It is difficult to show econometrically that Asian demand for US bonds since 2000 has had a material independent effect on US bond yields.
(4) A rapid dollar depreciation is STIMULATORY to US GDP, not recessionary. Episodic spikes in US bond yields MIGHT occur, but the experiences of all the countries mentioned in (1) above shows that this has a negligible impact on real activiey, and is overwhelmed by the export-stimulus of a falling currency.
Posted by: Peter vM at December 7, 2004 04:11 AM
Hey Prof!
Comments seem thin on the ground. Do your comment spam filters work too well?
Posted by: dilbert dogbert at December 7, 2004 06:14 AM
"America has enjoyed another huge advantage in its ability to borrow in its own currency. . . foreign creditors carry the currency risk on America's $11 trillion-worth of gross liabilities...."
The worry is that the rest of the world will get very upset at the abuse of this enormous privilege. An Op-Ed piece in today's NYT recommends a holding tactic: Washington should pursue a formal agreement with Europe, Japan and China on monetary policy, including exchange rates.
The International Monetary Fund could of course have pursued the matter internationally, had it not been neutered by the Plaza Accord in 1985. Perhaps the IMF could be reinvigorated?
Posted by: IJ at December 7, 2004 07:41 AM
Interesting. On a related note, http://www.nytimes.com/2004/12/07/opinion/07garten.html?oref=login&pagewanted=print&position
Yale's cheif MBA, Jeffrey E. Garten, says we shouldn't let the dollar be devalued.
Instead, we should, ummm, uh, oh yeah, let the dollar be devalued, but in a gradual and orderly way.
That's the ticket!
Posted by: Steve Holmes at December 7, 2004 07:56 AM
So, the US overtook Great Britain as a reserve currency. Does anyone suppose that part of this was because the US was a country on the way up, and Great Britain was on the way down (where is their empire now, compared to 1910?)
Has anyone who has looked at the demographics for Europe (especially Old And Getting Older Europe), and then looked at *their* projected problems with their health insurance and retirement insurance come away with the idea that Europe is an area on the rise? Copme on.
China or India, some day? Maybe. But it was only a few years ago that The Economist wrote a long article on demographics arguing that America may be even more dominant in 2050 than it is today.
http://www.economist.com/agenda/displaystory.cfm?story_id=1291056
Posted by: Tom Maguire at December 8, 2004 11:08 AM
So, the US overtook Great Britain as a reserve currency. Does anyone suppose that part of this was because the US was a country on the way up, and Great Britain was on the way down (where is their empire now, compared to 1910?)
Has anyone who has looked at the demographics for Europe (especially Old And Getting Older Europe), and then looked at *their* projected problems with their health insurance and retirement insurance come away with the idea that Europe is an area on the rise? Come on.
China or India, some day? Maybe. But it was only a few years ago that The Economist wrote a long article on demographics arguing that America may be even more dominant in 2050 than it is today.
http://www.economist.com/agenda/displaystory.cfm?story_id=1291056
Posted by: Tom Maguire at December 8, 2004 11:35 AM