SYNOPSIS: Looks at the rationale of a drop in the dollar

Time does fly. A year ago Asian currencies were plunging, hedge funds were attacking, and the world seemed on the brink of crisis. Now Asian currencies are if anything too strong, it's the dollar that's under pressure - and the world is, possibly, on the brink of another crisis.

Is all the buzz - from investment newsletters, the Medley Report, and so on - about a looming dollar crisis justified? The truth is, I don't know: while the dollar is surely overvalued on any "sustainability" calculation (see below), so is the stock market, and that bubble has gone on for a very long time. But people in Washington are reported to be worrying about the subject (although the Medley Report's statement that there is a formal working group turns out to be untrue), so some outside kibitzing seems to be in order.

Let's run through four questions:

1. Why should we believe that the dollar is overvalued, and hence due for a fall?

2. Why might a dollar decline turn into a dollar plunge?

3. Why would that be a bad thing?

4. What should be done about it?
 

1. Is the dollar overvalued?
 

The basic reason for believing that the dollar is overvalued is, of course, that the United States is running very large current account deficits, and that the possessors of other major currencies - especially the yen - are correspondingly running large current surpluses.

Now current account imbalances are not necessarily a warning sign. Indeed, they are the necessary counterpart of any transfer of funds from places with excess saving (Japan) to places with high returns on investment (the U.S.). Still, massive current account imbalances mean that the surplus countries are holding an ever growing share of their wealth in the deficit countries, a process that cannot go on forever; and (Herbert) Stein's Law reminds us that things that cannot go on forever, don't. Eventually the U.S. deficit and the rest-of-world surplus must be sharply reduced, perhaps even reversed; and while this adjustment could take place in other ways, it is likely that much of it will occur via a decline in the value of the dollar vis-a-vis the yen, the euro, and so on.

The "sustainability" question - which as far as I know I first posed back in 1985, in a paper titled "Is the strong dollar sustainable?" - is whether the market seems to be properly allowing for that required future currency decline. If not, the dollar is doing a Wile E. Coyote, and is destined to plunge as soon as investors take a hard look at the numbers. (For those without a proper cultural education, Mr. Coyote was the hapless pursuer in the Road Runner cartoons. He had the habit of running five or six steps horizontally off the edge of a cliff before looking down, realizing there was nothing but air beneath, and only then plunging suddenly to the ground).

And the numbers do have a definitely Coyoteish feel. True, interest rates in the United States are higher than those in Japan or Europe, which means that the market is in effect predicting gradual dollar decline. But inflation is also a bit higher in the United States; the real interest differential on long-term bonds is probably only about 2 percent vis-a-vis Japan, less vis-a-vis Europe. Thus investors are implicitly expecting only a 2 percent per annum real depreciation of the dollar against the yen over the long term; given the size of the current account imbalance, that just isn't enough. Beep beep!

2. A dollar plunge?

There are, then, good reasons to expect a dollar decline, perhaps even a sharp drop as markets start to pay attention to trade numbers again. Remember that in 1985, when the U.S. current account deficit was about the same share of GDP as it is today, a revision of market perceptions caused a drop from 240 to 140 yen, from 3.3 to 1.8 Deutsche marks.

But there is also a new element, which could amplify dollar decline, and cause a truly dramatic plunge: balance-sheet domino effects. According to people who ought to know, the "carry trade" that did so much to drive exchange rates last fall is back in force: a relatively small group of highly leveraged investors have borrowed in yen (and euros? the gossip is less clear) and invested the proceeds in higher-interest dollar assets. Should the dollar fall sharply, they will suffer losses - which will force them to contract their balance sheets, selling dollars, and driving the currency lower still, in what could be a massive overshoot.

Now Rube Goldberg effects - mechanical linkages via balance sheets, producing predictable mispricing - aren't supposed to happen in an efficient financial market. Efficient markets theory would tell us that in the face of an excessive depreciation of the dollar investors would recognize the long-term profit opportunity and buy greenbacks en masse - long-sighted Buffetts compensating for the balance-sheet problems of the hedge funds. Well, maybe - but maybe not.

3. Who cares?

Currencies rise, currencies fall. Isn't it a zero-sum game, and for that matter aren't the stakes pretty small in any case?

In general, yes. And even if we are now facing an unsustainable dollar overvaluation comparable to that of early 1985, those old enough recall that despite grim warnings of an impending "hard landing", the correction of that overvaluation was almost entirely benign. (Yes, some claim that it led indirectly to Japan's bubble economy - but that is a complicated story).

But matters are a bit different now, because we start from a different place. Arguably, the state of the world economy right now is such that a sharp dollar decline would be contractionary almost everywhere (except Argentina and Hong Kong).

To understand why, bear in mind that a currency depreciation (or, more strictly, a revision of expectations leading to a currency depreciation - the exchange rate is, of course, an endogenous variable) constitutes a positive demand shock and a negative supply shock to the depreciated country. It is a positive demand shock because the country's goods become more competitive on world markets; it is a negative supply shock because import prices increase. And conversely, of course, a currency appreciation is a negative demand shock and a positive supply shock.

The reason to be concerned about a sudden dollar decline, then, is that it so happens that the United States is currently a supply-constrained economy, while much of the rest of the world is demand-constrained. So the net effect is negative almost everywhere.

In the United States, where wages are finally beginning to reflect a more-than-full-employment labor market, a sudden dollar decline would at least threaten to produce a wage-price spiral - and the mere threat would mean that the Fed would likely be forced to raise rates. Whether this would lead to a substantial contraction is unclear - who the heck understands aggregate supply behavior these days? - but a dollar decline is certainly not positive for the U.S. right now.

As for the rest of the world, demand shocks from a currency appreciation are normally easy to deal with: just cut interest rates, which among other things limits the appreciation. But of course Japan is firmly in a liquidity trap, and cannot cut rates; the euro-zone is not in a liquidity trap, but a sufficiently sharp dollar decline could put it into one. The only places that clearly benefit from a weaker dollar are demand-constrained economies pegged to the dollar; and Argentina and Hong Kong are just not big enough to change the general picture.

Simple textbook open-economy macroeconomics, then, tells us that starting from where we are right now - a U.S. economy at or beyond capacity, a large part of the rest of the world well below capacity, and in or near a liquidity trap - a drop in the dollar will be a global contractionary force. How strong a force? Well, it depends on the drop; if markets were to force the U.S. to move rapidly to current account balance or beyond, the numbers would be very troubling. This is unlikely, I think; but then serious crises usually are, ex ante.

4. What is to be done?

Can the disturbing scenario just sketched out be prevented?

The U.S. cannot, of course, relax its supply constraint. We've already had a virtual miracle in our ability to expand this far before inflation started to appear; it's not just silly but greedy to ask for another.

Can intervention stabilize the dollar? If it is sterilized, or more generally if it is not backed by some fundamental change in policies, the answer is probably not. Intervention can sometimes turn around a market panic, but it cannot sustain the unsustainable. Look at the issue from Japan's side: as I argued repeatedly last year, a liquidity-trap economy faces the persistent problem that it cannot get its currency weak enough, because even at a zero nominal interest rate its real rate is too high. You wouldn't expect sterilized intervention - or any intervention that does not change expectations about Japanese inflation - to work; and it won't.

What will work is radical monetary expansion in the demand-constrained economies - Japan definitely, maybe also Europe if necessary. I don't think I need to go through the logic again - it's all there in  Japan: Still trapped . But note that monetization will not only expand domestic demand, but help to limit the dollar's fall (and relax the "sustainability" constraint by increasing demand for U.S. exports). These are the same effects that would flow from interest rate cuts in the appreciating countries under normal circumstances.

And that is the main point. The last time we had a seriously overvalued dollar, the inevitable correction did little harm, mainly because the appreciating countries were easily able to expand domestic demand. If the current situation looks more troubling, it is because non-dollar countries cannot increase demand using conventional policies, and are unwilling to contemplate unconventional policies. That unwillingness, not the dollar per se, is the source of the problem.