Arnold Kling  

Dollar Bubble

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Brad DeLong continues to predict a crash for the dollar.


Japan, China, and other export-oriented East Asian economies are indeed eager to keep the value of the dollar relatively high, and their central banks have piled up close to $2 trillion in dollar-denominated assets. China's government regards the threat of capital losses on its dollar-denominated securities as less important than the need to maintain near-full employment in coastal manufacturing cities like Shanghai. After all, the ruling communist oligarchs have grown accustomed to a comfortable lifestyle. The last thing they want is mass unemployment and urban unrest to call their positions into question.

But if international currency speculators get the scent of near-inevitable profits from an ongoing dollar decline in their nostrils, all Asian central banks together will not be able to keep the dollar high.


I remember people attributing to Milton Friedman "Bet against the central bank," meaning that speculators would do well to be skeptical that currency manipulation by central banks will be successful. Of course, he would say that printing more money could depreciate a currency, but he did not believe in so-called sterilized intervention. (Anyone have a source for the Friedman quote, or am I passing on an urban legend?)

For Discussion. Is foreign central bank intervention really an important factor in maintaining the high value of the dollar?



COMMENTS (15 to date)
rvman writes:

Can you think of a good reason for these central banks to have $2 TRILLION in dollar-denominated assets, other than maintaining the dollar?

Another thing to note - these banks stand to show a loss of somewhere in the range of half a trillion dollars, if the dollar falls 25%. That's something like 3% of their combined GDP - not exactly chump change. Of course they are going to try to keep the dollar from falling. (And, of course they are going to see it crash sooner or later. If Soros weren't distracted by the US elections, he would have attacked already. Politics and government yet again standing in the way of efficient market action.)

Clarence writes:

Arnold,

Friedman's aphorism is...how many decades old? And for how many decades has Japan (etc) held increasing dollar reserves? Hint: Milton could not make a living trading.

I would suggeset that dollar bears are as motivated by ideology as by economics, especially since DeLong (and you) must know that there is nothing in the academic literature to support his conclusion, nor the necessary implication (that the trade deficit is exogenous to the capital surplus).

Rhetorically, the best DeLong can cite is Bergsten?? His ph.d. is from....oh, never mind.

Lawrance George Lux writes:

The Trade Deficit is the greatest threat We have, and central bank intervention cannot hold off the inevitable. Are these central banks trying to intervent? Yes, but they are not very effective, except for inflate their own money supply artifically with false Reserves composed of the Dollar holdings. Schmidt, back in the days of Versailles Treaty of the 1920s, stated that foreign Currencies were effectively impossible as Reserve holdings, the two Currencies would interact negatively, so their interaction became an inflatiionary spiral for both Currencies. lgl

William Woodruff writes:

Absolutely. If the dollar was not the worlds reserve currency (and held by the aforementioned central banks, and the worlds foreignors alike), we would not be in the trouble we are currently in (twin deficits).

Sam Jew writes:

I'd second that last comment. The twin deficits are the result of Asian central bank policies that are unlikely to go away any time soon as the memory of 1997 is fresh in their minds.

And now the tables have turned. America is now at the mercy of Asian central banks as they were once at America's within recent memory.

Fortunately, they're primarily interested in economic and social stability, and to a lesser extent, maintaining the value of their investments. But should push come to shove, it's America that stands to be hurt more than anyone else.

Bill Fellers writes:

I don't see how the trade deficit is such a big problem. I have a HUGE trade deficit with any number of supermarkets, retailers, etc. They don't buy anything from me! Isn't the trade deficit as much a product of America's incredible wealth as any other factor? Would folks be happier if we were so poor that we couldn't afford to buy anything form other nations, and we'd work for such low wages that we could produce cheap goods for export?

Of course foreign bank intervention is an important factor in the high value of the dollar. If you were holding billions of dollars in reserves, wouldn't you try to keep the dollar's relative value high compared to other currencies? If the US is a major importer of goods from your nation, isn't a strong dollar to your nation's benefit?

Sorry about all the rhetorical questions. It's a bad habit of mine.

Mark T writes:

A question. Who says the $ is high? All the conventional wisdom on a $ crash assumes that the $ is mispriced and being held up by this asset buying. Clarence is right, the current account deficit and the capital account surplus are two sides of the same coin. It is political motivation that dominates in calling the current account the problem. I.e. it's America's fault. This is not about excess imports because the strong $ is making everything so cheap to import and expensive to export. This is a lack of demand outside the $ zone. Also, China is part of a $ zone and it is entirely rational to build its financial assets in the same currency. Second, Japan is keeping competitive agaisnt China as well as America, not to support US consumers but to support Japanese producers.

A weaker $ is not desirable for anyone, it would make China more competitive and hit already anaemic non-US growth even harder. It would deal with a symptom, not a cause. Oh, and the big mac index says the correct value against the euro is 1.06

William Woodruff writes:

Bill,

A trade deficit reflects an imbalance . This balance was once (ago) remedied by central banks transferring gold. Now trade deficits are remedied by a devalued currency, this is why trade deficits matter.

Mark,

A weaker dollar IS desireable by some. Notably, domestic sellers whom export. A 'weaker' currency makes their products competitive in world markets. In addition, the US Federal Government must sell treasury bills in dollars, and foreign investors (increasingly governments)find those treasuries more attractive at destressed prices (from a weaker dollar).Your comment about China is not quite accurate. The world market clearing price of the dollar has ZERO affect on the value of the YUAN (China's currency). The value of the YUAN is pegged (fixed, not subject to market forces).

A more sinister viewpoint pertains to inflation. If I were an owner of a specific asset class (real estate) I would LOVE the inflationary affect of a weakened currency !

William

Lawrance George Lux writes:

William,
Some even eminent Economists do not understand the reality of what the Trade Deficit is. Foreign central banks, no matter how hard they might try, are unable to see any difference between Dollars and Treasury bills. They are both printed guarrantees of the U.S. Government, the only difference being the Federal Governments offers to pay people to hold those Dollars.

The upshot of this discussion is the Federal Government is exporting Dollar Inflation overseas, and paying a premium for such export. The greatest Joke comes in Al Greenspan stating that Inflationary pressures are low. lgl

William Woodruff writes:

Igl,

Perhaps someone else might chime in on the economics of Trade deficits.

However, my understanding is, all deficits must be funded. Note, currently Australia is running a trade deficit of roughly 5.5% of GDP (one percentage point lower than the US). And yet they will enjoy a Budget Surplus this year and may have one next year as well.

I might add, the value of the Austrialian dollar on world markets is envious..

William

Paul N writes:

I say foreign purchase of US treasurys has little effect on the dollar's value. Foreign governments buy dollar assets because they see them as a good investment.

People that suppose a buyer alone can determine the value of a commodity are ignoring basic economics (i.e. supply and demand) and making one of the oldest mistakes known to mankind.

Say China's central bank, instead of treasurys, decided to purchase vast quantities of gold. Faced with the prospect of gold declining in value (for whatever reason, say a newly discovered supply), does China conclude: "If gold decreases in price, our portfolio will be decimated, so we have to keep buying gold to keep the price up"? Of course not, because the underlying value of gold is determined by its economic usefulness, even if a buyer is dominant enough to influence the price.

Sam Jew writes:

Paul, if they were on the gold standard, they would continue to buy gold even in the face of declining prices. As it happens, they a) they want to prop up the dollar to have a strong export market to keep people employed and not thinking about revolution and b) they need a reserve currency to defend their own from devaluation if they float or to make dollar-denominated purchases of commodities or whatever.

Prag writes:

A few thoughts:

From a strategic political point of view, I view it as a plus for the US to have China (Japan to some degree) hold large amounts of T-bills. We are essentially borrowing from China in order to get cheaper stuff today. China's industries, in turn, uses our consumption to fund their capital stock. So China needs our demand to move their productive capacity forward, and they are willing to do it with IOUs. That should give the US some power over China's decisions - after all, if it ever came to it, the US could simply default on it's foreign obligations...

It's pretty amazing the degree to which the Chinese are giving us their labor in exchange for pieces of paper.

I worry more about Japan's dollar demand drying up than China's and IIRC, China's trade deficit with the US is larger than Japan's.

Is foreign bank intervention key in influencing the value of the dollar? From my practical experience at a Fortune 50 corporate treasury, absolutely. As long as Japan and China are credible in dollar buying, the speculators won't bet against them.

It has long been my view that the three main influences on exchange rates are central banks, speculators, and trade flows. If the speculators believe that the central bank will defend to the death, then the speculators find somewhere else to play. From talking to traders, the speculators are more likely to play against central banks whose intervention policy they believe they can beat.

I think of it as a game, and central banks that have fundamental reasons to keep their currency low and a capacity to do so prevent trade flows and speculators from dominating.

It has to correct at some point in time, but I just don't see China & Japan allowing it to correct in a jump as it would destroy their economies. Imagine a billion pissed off Chinamen - it is conceivable that going back to their old standard of living could spark a revolution...

So I'd agree the demand for the dollar is artificial and probably a bubble, but unlike other bubbles, I just don't see this one popping with a big "pop", more like a slow leak, starting with China managing it's peg slowly towards a stronger remimbi.

Paul N writes:

Fine: if you think Treasurys are overvalued, if you think the dollar is overvalued, sell dollars and buy whatever foreign currency you like.

You see, your freedom to do this is what ensures that the dollar trades at what the market feels is a fair value.

Tom West writes:

after all, if it ever came to it, the US could simply default on it's foreign obligations...

Actually, given the catastrophic effects of US debt default (after all, the US needs to sell debt day after day, while the Chinese have no intention of redeeming their debt anytime soon), I suspect the shoe is on the other foot.

What if a China that was unhappy about US policy on Taiwan decided to sell every US-denominated asset in its possession? The unhappiness to the Chinese can be remedied (so to speak) by standard despotic methods. On the other hand, what would be the effect on the United States? (Actually, I'm quite curious. Has there ever been a reputable study on the effect of China dropping a dollar-bomb?)

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