Be afraid but not too afraid about the dollar

Longtime readers of this blog will recognize my occasional concern with the size of the trade deficit and the future of the dollar. On this question, economists split into two clear camps — camp one thinks the current equilibrium — in which the U.S. runs enormous current account deficits and Pacific Rim central banks provide the financing for said deficits — is incredibly fragile and that the dollar’s value will fall hard, fast, and soon. The other camp thinks that because most actors in the system have a vested interest in seeing the status quo persist, the current equilibrium is more stable than many think, and that over time, the dollar’s slow decline will help sort the system out. Today the International Monetary fund follows up on the World Bank’s warnings from last week and says that the current situation is not good. Andrew Balls provides a recap in the Financial Times:

The International Monetary Fund on Wednesday expressed frustration that rich and developing countries alike have failed to take the steps needed to reduce growing global imbalances. The fund has long been calling for efforts to increase national savings in the US, including cutting the fiscal deficit, structural reforms to remove obstacles to growth in Europe and Japan, and greater exchange rate flexibility in Asia to boost domestic demand…. The fund forecasts that the US current account deficit will grow slightly to 5.8 per cent of gross domestic product this year, with little improvement thereafter. Germany and Japan are both forecast to have surpluses close to 3½ per cent of GDP. “The US external deficit has so far been financed relatively easily, aided by continued financial globalisation,” the report said. “However, the demand for US assets is not unlimited… a continuing sharp rise in US net external liabilities will carry increasing risks.” As well as the possibility of a disorderly decline in the dollar, the fund identifed the possibility that inflation pressures lead to a spike in US interest rates, and the high and volatile oil price as key risks to the global outlook. The Bush administration’s pledge to halve the US fiscal deficit is not credible, owing to a number of items left out of the budget arithmetic, and “insufficiently ambitious” in any case, the report said…. China increased its foreign reserves by $200bn last year, as it intervened to keep its currency pegged to the depreciating US dollar. Other developing countries have built up big foreign reserves – partly to insure against financial market risks, and partly to maintain trade competitiveness. “A number of emerging markets, especially in Emerging Asia, have built up reserves to protect against everything short of the Apocalypse,” Mr Rajan [IMF chief economist] said, “The reserve build up is now undermining monetary control as well as the soundness of their financial systems.”

For more on the IMF’s reaction, see the transcipt of their press conference, as well as a link to their World Economic Outlook: Globalization and External Imbalances. This quote by Rajan stands out from the press conference:

The U.S., if it does not cut its fiscal deficit—the fiscal deficit is just one part. The other part is savings; private household savings have to also contribute. The fiscal deficit itself may not be enough. If U.S. savings do not increase adequately, you basically have to borrow from abroad. At some point, investors outside will have a tremendous amount of U.S. assets in their portfolio and will start worrying about their value and about whether they are adequately diversified. Essentially, to convince them to hold U.S. assets, one of two things has to happen: either U.S. interest rates have to go up way above the alternative opportunities these people have, or the U.S. exchange rate has to depreciate far enough that they feel that an appreciating exchange rate provides returns which give them incentives to hold U.S. assets. Neither of these is a particularly palatable outcome.

On the “don’t panic” side, James Surowiecki has an essay in The New Yorker concluding that although a hard landing would be bad, it probably won’t happen:

Markets are hardly known for their tenderness. Usually, you can assume that everyone in a market is trying to make as much money as possible, with as little risk, but the currency market isn’t like most others. In the market for the dollar, many of the players have other things on their mind. China needs to go on selling Americans hundreds of billions in exports in order to keep its economy humming. A weaker dollar makes that harder. Asian central banks also already own trillions of dollars in American assets. As the dollar falls, so does the value of those assets. There are plenty of other traders in the currency markets—who have the luxury of being single-minded regarding profit—but the Asian banks are powerful enough to be, in effect, the lenders of last resort. As long as it’s in their self-interest to keep America afloat, the dollar will not crash…. There’s a good chance, then, that the landing will be soft—we lose the truffles but keep our homes—as long as everyone involved in keeping the dollar aloft continues to play the same game. No one, in Asia or anywhere else, wants to be the last guy out. What the Chinese and the Japanese do depends in large part on what they think everyone else is going to do. If the Chinese get the idea that Japan’s commitment to the dollar is wavering, or if they decide that the United States has no interest in altering its deadbeat ways, then they may try to make a run for it. Then again, that threat could act as a prod to keep the Americans in line. The currency market is a great example of what George Soros calls “reflexivity”: people’s predictions about what will happen to the dollar end up having a major impact on what actually does happen to the dollar. Our lenders are trying to strike a delicate balance: they’d like the dollar’s predicament to seem dire enough to make us change, but not so dire as to spark panic. So be afraid. Just don’t be very afraid.