Tuesday, October 02, 2007

The Phantom Menace (update)

Last week I asked the readership to help me find good papers on the subject of a dollar decline. I thank everyone who sent me a suggested paper. Please continue to e-mail me interesting pieces at accruedint AT gmail.com.

Here are some of the highlights.

Paul Krugman "Will There be a Dollar Crisis?" Economic Policy July 2007.

Dr. Krugman has become more and more political, which is too bad from my perspective, since I think it has colored how people view his work. Say what you will about his politics, he has been one of the preeminent international economists for going on 3 decades.

Anyway, one of Krugman's strengths is his writing skill. I find his papers to be much more readable than most academics, without sacrificing weight. So this paper is a great read for anyone who isn't an economics PhD. Anyway, you can read his conclusions for yourself. I can't get past what seems like a core assumption of Krugman's in this piece.

Basically he says that there is a certain level of foreign indebtedness that's just plain unsustainable. Therefore the current account can't stay negative indefinitely. In order to correct this imbalance, the dollar must decline. None of these points are controversial.

If the dollar must decline, Krugman figures, why are investors still pouring money into U.S. assets? In other words, it sure looks like foreign investors in U.S. assets are buying investments with negative expected return. Krugman concludes that investors must be "myopic." Basically blindly buying U.S. assets while ignoring the fundamentals problem of our currency imbalance.

This sure sounds like a "the market is dumb" argument, and while Krugman himself cautions that second-guessing markets is dangerous, his "myopic" assumption is key to the idea that the dollar will suddenly fall. I learned a long time ago to beware the academic pedaling a model which is supposed to be smarter than the market. Now Paul Krugman isn't just any academic, but still, we must be cautious. And I don't have any particular reason to believe investors aren't myopic, but I also don't have any reasons why the are myopic. It seems just as likely that investors are reacting to something the models aren't modeling.

A couple other papers I found particularly valuable:

(Hat tip: Venkat) Jeffrey A. Frankel and Andrew K. Rose "Current Crashes in Emerging Markets: An Empirical Treatment" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 1996.

Christopher Gust and Nathan Sheets "The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 2006.

FYI, there are many good papers from the Fed on this topic, which can be found here.

I'm continuing to focus on this area, so the conclusions here are hardly my last word.


Deborah said...

Well, I think people behave far more based on what they know to be true in their past without looking too far beyond it and the types of economic conditions that now exist have been forgotten in the collective memory.

I would think that people who have lived though currency declines in their native countries and appreciate it was related to debt are concerned about investing in American assets.

Anonymous said...

In the land of blind men, the one eyed man is king...

People keep buying USD because there isn't really a viable option.

EUR is even more flawed (loads of debt, loads of off balance sheet entitlements, and mature economies -- plus too many cooks in the kitchen). CAD and Kiwi are nice, but way too small (and CAD is too dependent on the US). CHF is part of Europe no matter how much they fight it.

JPY is a mature economy with 150% debt to GDP and a bunch of geezers at the helm.

All the other markets in Asia are shallow, undeveloped and lack transparancy.

BRL might be a maybe, except for that pesky banana republic history. Plus the economy is too small to absorb much capital.

Russia may or may not be a kleptocracy depending on which day you look.

Most of the middle east is one bomb blast or one lucky shot away from overthrow.

Against all that, the US is still relatively transparent. It has deep, liquid markets. The economy is still the biggest single economy in the world. And everytime someone has written us off in the past, we did something bizare to get ourselves out of it.

No guarantees we can wriggle our way out of this -- but if you must place a bet, the US looks the least bad

Anonymous said...

Whether markets are myopic is not really the point - or at least not any longer. Over the last two quarters NET inflows into the US have come almost exclusively from official sources. Brad Setser - probably the expert on the issue - has been arguing this point for a while at his blog, and my own analysis confirms that he is spot on. So the real question is why (mainly) central banks are willing to pour hundreds of billions into dollar assets, and the answer is that they are doing if for - what their countries consider - a higher good, as preventing nominal exchange rate appreciation.

Accrued Interest said...

Wille and Bureaucrat: Both of you are saying what I've always thought, and so far no one has pushed me off my original premise. It wouldn't seem that any CB would diversify fast enough to cause a dollar collapse. Impossible? No, because its a market and markets are subject to panics, but I don't think betting on such a thing is very prudent here.

Anonymous said...

What is certainly, certainly true is that the dollar has been having an awful time against the euro.

Consider this: you bought 5% yielding bonds 10 years ago denominated in euros.

Today, in dollar terms, those bonds are yielding 10%. That's a nice investment.

Is that wrong?

Anonymous said...

I should add: 10% with no risk. Because they were European government bonds.

Unknown said...

Another very interesting paper is "The Unsustainable US Current Account Position
Revisited" by Kenneth Rogoff and Maurice Obstfeld, where they account explicitly for the large relative size of the USA economy.

Anonymous said...

IMO, the reason why foreign govts throw cash at us is because we are the Fort Knox of the world. We have the military might to protect their money. Swiss banks arn't big enough to handle all that money and those Swiss don't have any shock-and-awe firepower.