The dollar's steep decline has gotten a lot of talk lately, and with it fear that an even worse decline is on the way. No less than Paul Krugman thinks we're headed for a Wile E. Coyote moment, when the erstwhile predator realizes he's run off the cliff and suddenly plunges Earthward.
My own long-term view on exchange rates is that they are reflective of economic events, as opposed to being economic events in and of themselves. That's a bit of a simplification, to be sure, but consider what currency really is. Its just a means of exchange. We know that currency tends to decline in value over time, a process economists call "inflation." Why does currency movement have to be more complicated? In other words, if the dollar buys fewer ears of corn or fewer yen, what's the difference?
Classically, currency movement either reflects relative inflation in two countries (purchasing power parity) or relative real interest rates in two countries (i.e., that the country with higher rates will attract investment and therefore its currency will rise.) Given this, I wasn't initially concerned when the dollar declined over the last couple weeks. Given that multiple Fed cuts were being priced in by U.S. markets, its logical that:
A) Inflation would be on the rise in the U.S., diminishing the value of the dollar and
B) Interest rates were falling, causing foreign investment to be more attractive.
So a declining dollar seems to be the logical extension of what the Fed was doing. Not surprising at all.
However, there is a growing contingent of economists who believe a more severe dollar decline is likely, to the point where I don't feel comfortable merely dismissing the currency market as no big deal.
So I've embarked on a reading mission, where I'm going to be looking for any and all quality papers I can find explaining why the dollar is vulnerable (or not) to see if my classical explanation requires a bit more depth.
In order for me to be convinced that I should join the bearish dollar crowd, here are the questions I need answered:
- If the trade deficit is "unsustainable" at current levels, why has the U.S. been able to run a deficit more or less constantly for the last 30 years?
- Same question on foreign debt loads. They have been high for a very long time. Why are conditions today so different?
- If the answer to either #1 is that the deficit is historically large, then why is deficit of 6% of GDP a drastically bigger problem than 3 years of 2% deficits?
- Can the notion of Bretton Woods II be disproved? Or more to the point, what would cause China, Japan, and others to allow the U.S. currency to depreciate? Particularly in a sudden fashion?
- If we assume that a declining dollar coincided with inflation, this would likely cause the Fed to hike interest rates. Why wouldn't this attract foreign investment and thus strengthen the dollar?
- If the theory for a dollar decline is portfolio diversification on the part of central banks, why would these central banks choose to diversify suddenly?
- If the theory of a savings glut is accurate, then a dollar decline supposes that the glut of savings must travel elsewhere. But if there was someplace to travel, we wouldn't have a savings glut (or as some describe, an investment drought) in the first place. What's going to change in the short run?
I'm riffing a bit with these questions, so I'm sure I'm forgetting something. And many of these are related. But these are the questions I'm embarking to either confirm or deny. I'd appreciate links to any pertinent papers readers know of. Please e-mail me at accruedint (at) gmail.com.