Drooping Dollar (II): Will the greenback take a plunge?

By Phil Levy

Some discussions of the dollar’s recent fall have a tone of impending doom. They worry that the 15 percent drop of the last 6 months could accelerate out of control. The first post in this series argued that the recent decline has not been the result of manipulation, but that’s not saying that the dollar has reached a new equilibrium. This post will take on the question:

Has the dollar stabilized or is there risk of a further plunge in its value?

One way to rephrase this is to ask whether the dollar is reasonably valued right now. A classic measure is to take a bundle of goods (some groceries, some transport, some electronics, etc.) and ask what exchange rate would make that bundle cost the same in a pair of countries. The Organization for Economic Cooperation and Development (OECD) is one of several groups that produces these Purchasing Power Parity (PPP) estimates.

With these numbers, one can argue that it should take about $1.67 to buy a British pound. As I write this, the exchange rate is $1.63 – pretty close, with the dollar slightly overvalued. Other currencies look much different, though. For Germany, a PPP rate of 1.11 dollars to the euro compares with the current rate of 1.49. Instead of the PPP rate of 130 Japanese yen to the dollar, the rate is 91. In those cases, the dollar is badly undervalued.

While we’re playing with PPP exchange rates, we might as well check in on China. We’ve just been told that China is not a currency manipulator, but the PPP exchange rate is 3.4 RMB to the dollar, versus the market rate of 6.83 RMB to the dollar. That says several things. First, China’s currency is seriously undervalued. Second, PPP exchange rates are imprecise and can vary a lot. More careful estimates of China’s undervaluation run from 20-40 percent, not 100 percent. Finally, we can see that PPP rates offer only loose, long-term guidance about where currencies might go. They say very little about what will happen in the next six months.

In part, that’s because exchange rates are driven by investment decisions, not just the consumption of goods. Investors in Frankfurt and Tokyo ask whether they will make more money lending in euros or yen, or whether they would make more converting to dollars and buying American stocks or bonds. If they do invest in the United States, they’re going to have to venture a guess about what exchange rates they will face when it’s time to retrieve their funds.

How do they know what those rates will be? Here we land in the world of the Keynesian Beauty Contest, in which you get a prize for selecting the most popular contestant. While objective measures of beauty may offer a clue, the subjective preferences of the other voters are most important.

Applying this to exchange rates, we know objectively that currencies tend to suffer when countries have uncontrolled fiscal spending and growing debt. Persistent large trade deficits also suggest that a currency is due for a fall. Those are the situations facing the dollar. But the dollar retains value so long as everyone wants it – a self-supporting popularity. The concern is that a falling dollar will convince investors that their counterparts no longer find the dollar so beautiful and that a sharp unraveling in the dollar’s value could follow. In this scenario, the dollar wouldn’t fall without limit: at some point, US exports and facilities would look irresistibly cheap. But such downward spirals – the flip side of bubbling enthusiasm – can be dramatic and wrenching.

We thus have two contrasting views about where the dollar might go. On the one hand, cross-country price comparisons don’t look too bad for the dollar. They seem to support the more comforting story that the dollar’s recent fall is just the unwinding of its extraordinary rise as investors reacted to the crisis. On the other hand, the descent of the last six months looks very much like the start of a rush for the exits would look, as investors abandon the dollar and give in to their concerns about U.S. prospects.

It was just such a situation that prompted Harry Truman to cry out for a one-handed economist. In this case, though, the uncertainty is essential to the story. That’s one of the valuable economic insights that emerged unscathed from the recent crisis. To quote John Cochrane from the University of Chicago: “the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going.” In a nutshell, if we knew for sure that the dollar were to fall another 15 percent in the next six months, the fall would occur right now. Financial titans like George Soros would borrow dollars and buy other currencies, guaranteed to receive glorious returns. That would push the dollar down immediately.

So the dangers are real, but uncertain. They are particularly troubling because the bad scenario could have lasting effects. It could undermine confidence in the dollar that has supported its role as the world’s principal reserve currency. This potential has already led to calls for dethroning the dollar in such official transactions. Whether that’s a likely prospect will be the subject of the next post in the series.

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