Capital Flight is Good

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

1. Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
   
   
2. Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
   
   
3. Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
   
   
4. (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

Exchange Rate Expectations and Interest Rates

Since I’m (unhappily) short US Treasury bonds at the moment, I should be glad so many people think that uncovered interest parity means US bond yields have to rise when investors lose confidence in the dollar. (See the comments section of this post from Brad DeLong.) But it just ain’t so! Unquestionably, there are reasons to expect interest rates (bond yields) to rise when the dollar weakens, but those reasons are more subtle, and have different economic implications, than a brute force application of uncovered interest parity would suggest.

The theory seems simple enough: if investors expect the value of the dollar to decline, they will require higher yields on their dollar-denominated bonds, to compensate for the lower exchange value of the dollars in which they expect to be paid. The problem is that people take the clause “investors expect the value of the dollar to decline” to refer to a condition independent of how investors respond to that condition. In most models, what actually happens when “investors expect the value of the dollar to decline” is that the value of the dollar immediately declines, and then investors no longer expect the value of the dollar to decline. And most of those models include uncovered interest parity.

Suppose international investors, holding US bonds, suddenly come to believe that the value of the dollar will decline. What do they do? First they sell their bonds, which does cause yields to rise temporarily, but… What do they do with the proceeds? Do they sit on those dollars and wait for yields to rise enough to entice them to buy bonds again? I would think not, if they expect the value of the dollar to decline: instead, investors convert those dollars into (for example) euros and sit on those euros (or invest them in European bonds) until some combination of interest rate and exchange rate movements entices them back to the US bond market. But they don’t have to wait very long, because, in the process of converting those dollars to euros, they have pushed down the value of the dollar sufficiently that it no longer needs to decline. Suddenly, with the dollar no longer expected to decline, US bond yields become very attractive. They become so attractive that investors bid yields back down to their old levels.

In the paragraph above, I’ve snuck in some elasticity assumptions to assure that the value of the dollar doesn’t rise again when investors convert their euros back into dollars to buy back the US bonds. In principle, interest rates and exchange rates should be determined simultaneously. But if we believe in the expectation-based world of uncovered interest parity, then we must also believe in a similar expectational parity between short-term and long-term interest rates. Short-term interest rates are set by monetary policy, and long-term interest rates depend on expectations of future short-term interest rates. So if we hold expected monetary policy constant, all interest rates will be constant. If long-term interest rates rose, investors would try to exchange all their short-term bonds for long-term bonds, but since monetary policy assures a perfectly elastic supply of short-term bonds, this process would not stop until long-term rates came back down. Under these circumstances, the only way the market can adjust to a loss of confidence in the dollar is by bidding down the exchange value of the dollar immediately, until it is no longer expected to fall.

Now, you might point out that expected monetary policy will likely respond to the declining value of the dollar by raising interest rates. That’s true, since the cheaper dollar makes US goods more attractive and thereby produces a stimulus that monetary policy needs to offset. But that is a consequence of the monetary policy reaction function and the goods market equilibrium, not a consequence of uncovered interest parity. And it doesn’t allow one to make the argument, “When investors lose confidence in the dollar, US interest rates will rise, causing the economy to weaken,” because the Fed is only expected to raise interest rates enough to prevent the economy from strengthening, not to weaken it relative to its original condition. There are other, more subtle arguments you could make about why interest rates might rise further (the inflationary impact of the J-curve, behavior of foreign central banks, etc.), and the economy might actually weaken, but we have already wandered far afield from uncovered interest parity. If you want to argue that a loss of confidence in the dollar will weaken the US economy, you’ve got a lot of explaining to do.

Is a Cheap Currency Good?

In the comments section of my first post about the euro, reader Keith asks:

1. Isn't it better to have a cheap currency? You get to export more and bring in more money. A cheap currency hurts if you travel outside the country, but on the other hand, you have more money to spend because you export more.
   
   
2. Why has the US followed a strong dollar policy? It seems Japan has had the right idea by keeping their currency cheap.

The simple answer to the first question is that a cheap currency is good for the tradables sector (exports, potential exports, and industries that actually or potentially compete with imports) but bad for the notradables sector (everything else). It’s bad for the nontradables sector because the economy has limited resources, and the additional resources that get used in the tradables sector are no longer available for use in the nontradables sector. For example, China has a cheap currency, and it has thriving export industries, but it has really bad health care, presumably in part because people who could be training to be nurses find it more convenient to take factory jobs in the export sector.

There are any number of problems with the last paragraph. For one thing, Gabriel is probably going to complain about my cavalier use of the words “good” and “bad.” I’m pretty sure that, in a model with nominal rigidities, fixed capital, and search costs, a cheap currency can be shown to have good and bad welfare consequences (respectively) in the short run for people associated with those respective sectors. But I’m also quite sure that the proof would be a pain in the ass, and I expect that somebody (I have no idea who) has already done it, so I’m not going to attempt it. As for the long run, exchange rates are irrelevant because prices and wages adjust completely. (Well, not really irrelevant, because there is path-dependence: what happens in the particular short runs helps determine the long-run equilibrium. But that’s getting too deep for now.)

The second problem is that the phrase “limited resources,” while quite valid, is misleading. Resource limitations are not a simple, tight constraint. There is always some unemployment, and always some idle capacity, so there is always the opportunity to push on resource limitations. The problem is, when unemployment gets too low, or capacity utilization gets too high, then inflation starts to accelerate. And it’s never exactly clear how low is too low and how high is too high. If the country has plentiful slack resources, then a cheap currency is good for everybody. If the country is already overutilizing its resources, a cheap currency could be bad for everybody if it causes an inflationary spiral (but if the central bank is on its toes, this presumably won’t happen).

The third problem is that my China example is not a very good one. (Maybe someone else can think of a better example.) China’s health care problems have more to do with bad insurance markets than with potential nurses becoming factory workers. And China’s construction industry – also part of the nontradables sector – seems to be doing fine. China is quite an interesting case, though, because, on the one hand, it appears to have plenty of slack resources (people working inefficiently in agriculture who can easily take factory jobs) and therefore one might think that there is no disadvantage to a cheap currency. But on the other hand, it is beginning to experience an inflation problem, which would suggest that it is getting the worst disadvantage from a cheap currency. Part of the solution to this paradox, I think, is that China is trying to mobilize its slack resources too quickly and running into bottlenecks. And there’s also the issue of natural resources. I could go on and talk about China’s potentially destabilizing absorption of massive dollar reserves and about China’s possible attempt to exploit path dependence and so on, but I want to get to the second question.

So, why has the US followed a strong dollar policy? And should it? In the late 1990s, I think a strong dollar policy made sense (though Dean Baker disagrees). The reason it made sense is that the nontradables sector in the US was doing a lot of useful things – creating new technologies and investment goods to make US production more efficient in the future – and a weaker dollar would have forced a shift of resources out of the nontradables sector.

Today, though, I don’t think a strong dollar makes any sense, and I think most economists would agree. The economy is weak, and we may be going into a recession, so there are a lot of potential slack resources, and the nontradables sector in recent years has not been doing anything terribly useful with its marginal capacity (mostly building a lot more houses than we really need). That doesn’t necessarily mean, though, that a “strong dollar policy” is a bad idea, if a “strong dollar policy” just means a lot of cheerleading by the Treasury Secretary. I think most economists would agree, what we want is for the dollar to fall slowly, so as not to destabilize markets or cause a bout of inflation. But if investors expect the dollar to fall slowly, they will all sell their dollar assets, and the dollar will fall quickly. The solution, I suppose, is for Hank Paulson to keep saying we like a strong dollar and to convince a gradually decreasing number of suckers that he really means it, so they will wait before selling their dollar assets and prevent a free fall.


[Afterthought: I’m beginning to wonder, though, whether the dollar still is very much overvalued against the euro. It’s getting easy to imagine that, at a dollar/euro exchange rate not too far from the present level, once temporary effects wash out, the Euro Zone and the US could both end up with moderate trade deficits, rather than (as it has been recently) the US having a very large deficit and the Euro Zone having roughly balanced trade. Increasingly, the problem is not an overvalued dollar but undervalued currencies that happen to be pegged to the dollar but that perhaps at this point might almost as well be pegged to the euro.]

Why doesn’t Europe have a large trade deficit? (Part 2)

The first rule of this game is that you’re not allowed to answer, “Because Europe has a high savings rate.” The whole point of Paul Krugman’s post to which I linked in Part 1 (as well as this 1995 Krugman piece to which he links therein) is that there has to be some mechanism by which a higher savings rate leads to a smaller trade deficit (or a surplus). The usual mechanism is the exchange rate, but in this case, the dollar has not appreciated against the euro. (It has depreciated in nominal terms and probably mildly depreciated in real terms also.) You can’t just say that when people save more, they buy fewer imports: if this were the only mechanism, then an increased savings rate would necessarily lead to a huge recession, because people would also buy fewer domestic products. Once the central bank and the financial markets make the necessary adjustments to avoid that recession, they increase the demand for imports again, and we’re back where we started. Unless something else – such as the value of the currency – changes.

I’m somewhat disappointed that I haven’t yet seen an answer that is both convincing and conventional. Apparently, there is no easy story that explains the divergence in trade balances between the US and Europe. (When I say Europe, BTW, I mean the Euro Zone – since I’m speaking with reference to exchange rates. Steve Waldman points out that there is diversity within the Euro Zone, with Germany running a surplus and most of the others running deficits. At a pinch, I’ll make this whole discussion about Germany and say, “Why does Germany still have a trade surplus?”)

There were a couple of interesting unconventional answers that involve complementarity. Karl Smith (in a comment that he develops more fully on his own blog) suggests a complementarity between Asian production and US distribution. In this story, the major cause of the US trade deficit is what might be called the “Wal-Mart effect.” Imports have become cheap to buy in the US, not so much because they have become cheap to produce in Asia, but because US retailers have learned to operate on thinner margins. European retailers, on the other hand, have not.

A couple of people hinted at another possible complementarity: between European (i.e., German) exports and the Asian production process. If the Asian (Chinese) investment boom has created a specific demand for European (German) capital goods, then the resulting export demand could outweigh the effect of euro’s appreciation. It’s not entirely clear to me why it wouldn’t also create a demand for (presumably cheaper) US capital goods, but then I know very little about the details, so perhaps US capital goods just aren’t the kind that China needs.

Some people suggested various things, such as European protectionism and the VAT, that might help explain why Europe has in general had a stronger trade balance than the US, but as far as I can tell, they don’t explain why the US has developed a trade deficit over the past decade and Europe hasn’t. The VAT was there a decade ago, when the euro was weaker and Asia was less productive, so why didn’t Europe have a large trade surplus at that time?

Gabriel M. asks why it all matters. He wants the answer to boil down to welfare. Steve Waldman gives an answer which may help satisfy Gabriel. As for me, I don’t have an answer that boils down to welfare, because in this case I’m one of the agents trying to form my own expectations about exchange rates. The observation that the US is importing a lot more than it is exporting, and the presumed unwillingness of people outside the US to keep sending goods to the US without eventually receiving something in exchange, suggests to me that the dollar is overvalued. The fact that a similar argument cannot be made for Europe suggests that the euro is undervalued against the dollar. But I’m troubled because there is a piece of the puzzle that doesn’t seem to fit.

Why doesn’t Europe have a large trade deficit?

Paul Krugman (hat tip: Greg Mankiw) points out that, for national savings (and investment) to affect the trade balance, it first has to affect the exchange rate. (In particular, if the US had a higher savings rate, the trade deficit wouldn’t fall unless the dollar depreciated further, so it is absurd to blame the weak dollar on the low savings rate.) One of the implications of this realization is that one can talk about the immediate causes of trade imbalances without mentioning national savings or investment: the cause has to be either in the (real) exchange rate or in the business cycle.

In terms of exchange rates, it’s pretty easy to see why the US has a large trade deficit today. (For now I’ll leave out the oil issue, though that’s part of the explanation.) The Asian countries (and China in particular) have become dramatically more productive over the past decade. Therefore their prices for traded goods have fallen dramatically, but they have not allowed their currencies to appreciate commensurately. Consequently, the dollar is overvalued (in real terms) relative to those currencies today. Ergo, the US has a trade deficit.

OK, so far it makes sense, but wait a minute: productivity growth in Europe has not been much faster than productivity growth in the US over the past decade. Prices of traded goods produced in Europe have not fallen. The euro has not, on balance, depreciated against the dollar. And Europe didn’t have a huge surplus with the US a decade ago (despite the booming US economy at the time). So if Asian goods are cheap today relative to US goods, then Asian goods must also be cheap relative to European goods. So why doesn’t Europe have a large trade deficit like the US?

If I get a chance, I’m going to download actual data on trade balances and exchange rates and see if I can figure this out. For now, though, it’s a puzzle. And it makes me wonder if we should start to get really worried about Europe’s trade balance now that the euro has appreciated dramatically against the dollar.

Not Hitting the Fan Yet

The dollar is now at a record low against the Euro, down more than 20 percent from its peak in 2002, down so low it’s about equal to a Canadian dollar.

So begins Robert Reich's blog post to which I referred on Friday. By my arithmetic the situation is even more extreme, with the dollar having lost about 40% of its value in Euros since the 2002 peak. But should the drop in the dollar between January 2002 and September 2007 really be a cause for concern in the US?

I don't see why. Most of the drop happened in 2002 and 2003, and the remainder has happened slowly over the subsequent four years, with a slight acceleration over the past few weeks. That's water under the bridge. If that drop in the dollar were going to cause inflation in the US, or to cause a drop in US real incomes, it would already have happened.

But incomes (on average) have continued to rise, and as for inflation, I think the figures in the August Personal Income and Outlays report (see Tables 9 and 11, along with historical data available here) should put to rest any immediate concern. Looking at my favorite inflation indicator, the market-based personal consumption deflator excluding food and energy, we have the following annualized (logarithmic) growth rates:

1 month    1.15%
2 months   1.34%
3 months   1.39%
6 months   1.18%
9 months   1.67%
12 months  1.61%
18 months  1.89%
2 years    1.87%
3 years    1.80%
4 years    1.70%
5 years    1.57%
6 years    1.56%

None of this suggests that inflation has yet become a problem at all. Given the presumed target of 1.5%, the recent data would even make a better case for worrying about deflation than about inflation. (Remember that food and energy prices can be quite volatile, so one shouldn't ignore the risk that, for example, a reversal in the oil market could send the full deflator quickly into negative territory.)

Though I have worried in some recent posts about the potential for a drop in the dollar to force the Fed into a stagflation regime, it needs to be emphasized that this worry is about the future and not about the present. If the s___ is going to hit the fan, this is actually a pretty good time for it to hit.

For Richer or Poorer

Robert Reich (hat tip: Mark Thoma) says that the weak dollar is going to make Americans poorer (except for those who are rich enough to hedge against the dollar’s fall) and that “the real worry isn’t inflation” but “our pocketbooks.” Reich’s scenario is indeed what you get from a comparative static exercise in a simple full-employment model: when the terms of trade shift against you, you end up worse off, and (provided nobody expands the money supply) inflation isn’t an issue because falling prices outside the tradable sector (like, let’s say, in housing) offset rising prices for tradables.

But real life is not a comparative static exercise, and everything else doesn’t get put on hold when we go from an old equilibrium to a new one. In the past, the overwhelming tendency has been for the US (as a whole, anyhow) to get richer over time, and I doubt that the terms-of-trade shock, by itself, will be enough to reverse that tendency over the next few years. The US may get a recession, and that may make the US temporarily poorer, but if we are heading for a recession right now, it is in spite of, not because of, the falling dollar. Aside from the possibility of a recession, the US capital stock will continue to grow as usual, technology will continue to improve as usual, and, provided that the terms-of-trade shock is not too precipitous, improving domestic productivity will offset the deteriorating terms of trade.

What if the terms-of-trade shock is too precipitous? Then the US will get poorer, temporarily, but the long-run improvement in productivity will continue, and after a few years, we should catch up again. But a precipitous shock would lead me to question Professor Reich’s assertion that “the real worry isn’t inflation.” A sudden deterioration in the terms of trade would (as I argued in my earlier posts about labor cost targeting) put the Fed in a difficult position. Given the stickiness of many domestic wages and prices, the diminution of living standards that Reich foresees would not happen without a fight, and the result of the fight would be either inflation or recession. I would be more worried about either of those possibilities than I would about the fact that some people will have to make modest reductions in their standards of living.

It’s also not unthinkable that the falling dollar could end up improving US living standards, paradoxical though that may seem. The overvalued dollar has pushed a disproportionate fraction of US resources into the nontradable sector. One has to wonder whether this imbalance has damaged productivity growth. It’s a lot easier to imagine productivity growth happening in tradable industries like manufacturing and Internet-based services than in, say, construction and mortgage finance. Surely real investment will make a much greater contribution to productivity if it goes into plant and equipment for export industries rather than into residential housing. And as one who believes that there is more slack in the US labor market than is generally recognized, I hold out the hope that the stimulus from a weak dollar will help us discover that slack and give the US a Keynesian free lunch to offset the rising cost of the French wine we’ll be drinking with that lunch.

Professor Reich also suggests that the weak dollar will have a regressive effect on distribution, but again I’m skeptical. The tradable sector is where most of the good working class jobs are (or were, and presumably could be again). Reduced foreign competition will also put workers in a better position to negotiate a bigger slice of the pie in industries where there’s room for negotiation. If it becomes relatively more economical to produce in America, that’s no net advantage for the world’s capitalists (who will lose, for example, on European production what they gain on American production), but it will be a big advantage for the American workers who are available to do the producing.

Having said all this, I want to point out that, while the prognosis for the dollar is certainly not good, reports that the dollar is already dead have been greatly exaggerated. Yes, the dollar is at a record low against the Euro, but this doesn’t mean that the dollar has crashed. It just means that the dollar’s general downtrend, which has been in place for five years, is continuing, and that we happen to have been in a declining phase of the variation around the trend. There is a good chance that the dollar will keep going down from here and that the general trend will accelerate. But that’s hardly a foregone conclusion. Anyone who remembers the fall of 2004 should know to be cautious in extrapolating the weak dollar into the immediate future.

Holy S___, Batman, Look at the Foreign Exchange Market!

In reaction to my last post about the s___ that may soon hit the fan and why labor cost targeting would help, Gabriel M. suggests that I discuss the nature of the s___ in question and how it came about. In a nutshell, the issue is that most economists (not all, but I would say the vast majority) think the dollar is significantly overvalued. For the moment, the market seems to disagree, inasmuch as interest rates on dollar-denominated bonds are not much higher than those on bonds denominated in, for example, euros. In theory, if people believed the consensus of economists, it would be a no-brainer for anyone with an international bond portfolio to dump their dollar assets and replace them with other assets such as euro bonds. (It’s implausible to me that the slight difference in nominal creditworthiness between the US treasury and, say, the German treasury, is enough to make this less of a no-brainer.) If everyone were doing that, dollar interest rates would already be significantly higher than non-dollar interest rates.

I don’t think I’m going too far out on a limb to say that, historically, when economists and the market disagree, the economists usually eventually turn out to be right (though the economists are usually wrong about how long it takes to get to “eventually”). A case in point is the last time the dollar was regarded as severely overvalued, in 1984. It may have taken an international agreement (the 1985 Plaza Accord) to get the dollar on a downward path, but once the decline started, it was beyond what international policymakers seemed able to control. Anyone who listened to economists in 1984 about the dollar, and then changed his mind when they turned out at first to be wrong, would have been extremely unhappy by late 1987.

I should note in passing that there were factors present in the mid-1980s that mitigated, and even reversed, the supply shock from the falling dollar. In 1985, when the dollar began to decline, the US was still recovering from worst recession since the 1930s, so there was considerable slack in the economy. (There may be considerable slack today, too, but that’s not the consensus.) Also, as a consequence of having shown itself willing to induce and prolong the worst recession since the 1930s, the Fed had a surplus of inflation-fighting credibility. And since the dollar had been continuing to rise until early 1985, there was something of a favorable import price shock already in the pipeline to offset the subsequent unfavorable one. Then in 1986, OPEC members were unable to reach agreement on new quotas, and the price of oil dropped dramatically, providing a favorable supply shock to (probably more than) offset the unfavorable shock from the falling dollar. Another factor was that many goods sold to Americans were (either explicitly or implicitly) priced in dollars, so the import price shock from the weak dollar was not as strong as it otherwise would have been. The same is true today, but less so.

Part of the reason that the dollar remains overvalued is that much of the investment in fixed income dollar assets comes from sovereign entities, such as the People’s Bank of China (PBoC) or the Saudi Arabian Monetary Authority (SAMA), that are less concerned about profit and loss than private investors. But even such entities are not entirely oblivious to profit and loss, and lately there are increasing signs of their desire to diversify away from the dollar. In doing so, they would also probably have to give up the currency pegs that have kept the dollar overvalued relative to their own currencies. SAMA gave the world a bit of a shock recently, when it uncharacteristically failed to echo the Fed’s interest rate cut. From China there are vague noises about the “nuclear option” of divesting of US bonds, which would entail dropping the dollar peg entirely. And China’s rising inflation rate is, one may presume, making it clearer to the Chinese authorities that continuing the peg in its current form is not in their national interest. So there are obvious cracks developing in the structure that has supported the overvalued dollar.

Another factor is the low national savings rate in the US, evident in both the negative personal savings rate and the federal fiscal deficit. With Americans not saving, the nation as a whole needs to attract capital from abroad, and that demand tends to keep interest rates high enough (relative to foreign rates) to keep the dollar from weakening too much. (My Keynesian self is telling me that is a big oversimplification, but I don’t want this post to get too long.) The risks here are (1) that (because of liquidity constraints due to falling home prices, or because of demographics, or just because of an attack of prudence) the savings rate could rise, taking away this support for the dollar, and (2) that, if the savings rate does not rise, foreign investors will lose confidence in the creditworthiness of the US and dump dollar assets until the dollar weakens or US interest rates rise.

The low savings rate in the US is necessarily offset by an excess of savings over investment abroad – the so-called “savings glut.” There’s a bit of a chicken-egg debate about which of these is the first cause, but from the point of view of the exchange rate, it doesn’t much matter. If the savings glut is the primary cause (a view to which I’m sympathetic), then the glut itself is arguably what has supported the dollar. However, the scenarios described in the previous paragraph still apply: (1) if Americans become no longer willing to absorb the excess savings, then the dollar will drop; (2) if international savers begin to think that the US is not a good place for their savings, then the dollar will drop. (The first of these scenarios – which I will call the “ice” scenario – is particularly troubling because, while it could be an inflationary shock for the US, it could at the same time be a particularly strong deflationary/recessionary shock for the rest of the world.)

So, whether or not it happens immediately, chances are there will be downward pressure on the dollar in near future, and we cannot assume that the market’s response will be orderly. If the dollar drops quickly, the price of imports would likely rise much faster than the US economy can adjust by shifting demand and production to domestic producers. That’s a classic example of an import price shock, and it would likely cause a rise in aggregate US consumer prices out of proportion with its relatively mild stimulative initial effect on US output (though the latter should increase over time). The shock will likely be exacerbated by rising commodity prices (including oil), as demand by stronger-currency countries pushes up the dollar price of commodities. (It’s debatable whether the last point has any real substance: most commodities are priced in dollars by convention, and their price in terms of some hypothetical “average” currency should not be affected by exchange rates. In theory, rising dollar commodity prices are just part of the original exchange rate shock, but when oil goes to $100, it will certainly get separate coverage in the media.)


Unfortunately, the prospects for anything even vaguely resembling explicit labor cost targeting are dismal at best. So I have left two great hopes for avoiding an unpleasant outcome for the US. First, that the rise in import prices will continue to be slow enough to avoid having much inflationary impact. Second, that there is more slack in the US labor market than the consensus recognizes, and this slack will absorb much of the price shock. Even if my hopes are realized, the outcome will be less than optimal, but then, when do we ever get an optimal outcome?

Shorter Case for Labor Cost Targeting

Look, there’s a good chance the s___ is going to hit the fan in the next few years, if not in the next few weeks**, with a crash in the dollar and a takeoff by commodity prices, especially oil. The Fed has 3 choices:

1. It can wait for the s___ to hit the fan and then do nothing.* Bond markets, product markets, and labor markets will lose confidence in the Fed’s resolve for price stability, and the result will be stagflation (a concept with which readers my age and older will be familiar from experience, but younger readers may have to use their imaginations).
   
   
2. It can wait for the s___ to hit the fan and then tighten aggressively. The result will be a major recession.
   
   
3. It can “announce” as soon as possible that it intends to target labor costs, and when the s___ hits the fan, do nothing.* The result, with any luck, will be a couple of years of high inflation rates, with normal economic growth, followed by more normal economic growth along with low inflation rates.
   

I’m just saying, choose what’s behind door number 3. It doesn't really matter if you're a capitalist or a worker or a rentier or a financial technocrat or what. It's just the best choice.


*That is, nothing except for a mild tightening to offset the economic stimulus from the weaker dollar.

**UPDATE: Let's say quite possibly in the next few weeks, if not in the next few days. The following item appears in my email this morning:

Venezuela’s state-run oil company has demanded payment for all future sales of crude and products to be in euros rather than US dollars, according to a letter to customers on September 21.

50 Basis Points

I don’t expect that the Fed will cut the federal funds rate target by 50 basis points at its next meeting, but I do think that would be a good idea. (This conversation started on William Polley’s blog, but it’s going to get too long for a comment.) I see every reason to prefer erring on the side of too much stimulus rather than too little:

1. With the release of the payroll employment figures for August, as well as the revisions for June and July, not to mention the widely expected prospect of additional downward revisions when the real data on births and deaths come in, we face the serious possibility that the US was already in a recession when August’s financial crisis hit. (That’s in addition to the possibility that we went into a recession in August, and the possibility that the effects of the financial crisis will tip us into recession over the coming months.) If it turns out that the recession began before the financial crisis, we will be experiencing a deepening recession over the coming months, and
   
   
2. that recession could get really ugly. Although I made optimistic noises last year about the tractability of any possible recession, I am becoming increasingly worried about the possibility of a policy-resistant recession. Consider that
   
   
   • the international savings glut is still with us, and, if anything, it’s about time for the US to join the glut rather than playing the hero, as
     
     
     • American households have had a negative personal savings rate for two years, and this is unlikely to continue given the now more limited prospects for capital gains on assets and more restricted access to low-priced credit.
       
       
     • America’s children are about to graduate from college, which puts Mr. and Mrs. America at the point where it’s time to stop worrying about the kids and start panicking about inadequate retirement savings.
       
       
     • tax cuts are going to expire soon, and the Democratic congress is unlikely to extend them.
     
     
   • If the international savings glut should disappear, then we face the prospect of a potentially stagflationary fall in the dollar, which would inhibit the use of policy to end the recession.
     
     
   • A conventional monetary stimulus may in any case prove ineffective, given the “once bitten” status of the housing market and the unresponsiveness of capital spending. I don’t think Ben Bernanke wants to be in the position of having to use his helicopter.
   
   
3. By the standards of the last 50 years, the inflation rate is damn low. The 12-month growth rate of the core consumption deflator is within the target range. Inflation expectations are well-contained by almost any reasonable measure – with median expected 10-year CPI inflation (according to the Philadelphia Fed’s Survey of Professional Forecasters) recently falling below the 2.5 percent level where it has spent almost all of the past 10 years. The weight of risks is overwhelmingly on the side of too little growth rather than too much inflation.
   
   
4. From an economic point of view, monetary policy will still be tight, even after a 50 basis point cut. If you take the rule of thumb that the neutral real overnight interest rate is 2%, and add that 2% to the core PCE inflation rate, you get 3.9%. OK, maybe you don’t buy that – so make it 4.2%, or even 4.5%. But 4.75%? No way is that a stimulus policy.
   
   
5. The longer-term prospects for the dollar are dismal, but at this moment, everyone wants dollars – probably because so many foreigners are trying (or being forced) to unwind levered positions in dollar-denominated assets. Instead of saying, “Let them eat euros!” why not give them the dollars now, and you can take them away later if necessary. If the stimulus turns out to be ”too much” from a business cycle point of view, so much the better from an “orderly foreign exchange markets” point of view. When the world has had its fill of dollars and the thought of the dismal US international investment position starts to cause indigestion, it will be just in time for the Fed to prevent a free fall by raising interest rates in the face of an overheating economy. I’m not advocating exchange-rate targeting, and under normal circumstances, I would say that the Fed should ignore the value of the dollar (except to the extent that it alters the picture for expected employment and inflation). But after so many years of huge and growing current account deficits, these are not normal circumstances; the Fed needs to worry about how potential exchange market instability might constrain its future actions.
   
   
6. History will forgive a recently appointed central banker for overreacting to a financial crisis. (It surely forgave the former Chairman when he overreacted to the stock market crash.) History will not deal so kindly with a central banker who allows the economy to fall into an intractable recession. When the Emperor smells smoke, even if the odor is rather faint at first, he had best put down his fiddle.
   
   
7. One of the mistakes of the last easing cycle was not to cut aggressively enough in the beginning. Ultimately (we can say with hindsight) the easing cycle went too far, but it definitely started too slowly. The Fed was also too slow to ease in 1990-91. The Fed has a lot of inflation-fighting credibility today, and should the economy seem to move in the direction of overheating, the Fed can take back any easing moves without having lost much ground. But you don’t get a second chance to prevent a recession.
   
   
8. All the reasons that I have given already are things the financial markets can figure out for themselves. If the Fed only cuts by 25 basis points this month, markets will have good reason to expect another cut in October. If the Fed cuts by 50 basis points, it can credibly avow a reasonable hope that no further cuts will be necessary.

The New York Times on Exchange Rates

Greg Mankiw and Dean Baker are beating up on an editorial in today’s New York Times. I think their attacks are a bit unfair. The editorial says that the Bush administration is reducing the trade deficit by “letting the dollar slide,” which the Times suggests is not a good idea, but instead, “to be truly effective, a weaker dollar must be paired with higher domestic savings.” Greg and Dean ridicule the editorial by pointing out that a weaker dollar is exactly the mechanism by which higher domestic savings would reduce the trade deficit. (Dean also allows for the possibility that higher savings could cause a recession, which would reduce the trade deficit but obviously would not be desirable.) So if “letting the dollar slide” is a bad thing, they suggest, how could increasing domestic savings be a good thing, when increasing domestic savings would only cause the dollar to slide further?

I grant you the editorial does not appear to have been written by someone who had just finished getting an A in a course in open economy macroeconomics, but I think the editorial has a point, which Greg and Dean are missing. There are two reasons that the dollar can weaken. First, it can weaken because US interest rates fall (relative to foreign rates), making dollars less attractive. That is a “movement along” the demand curve for dollars. Second, it can weaken because people demand fewer dollars at any given interest rate. That is a “shift” in the demand curve for dollars*. What the Times is saying is that the right way to weaken the dollar is by inducing a movement along the demand curve, whereas Bush administration policies are instead causing the curve to shift.

While it’s debatable just how much influence public policy has on the position of the demand curve, it certainly has some influence. Surely Dean Baker, who perpetually complains about the Clinton-Rubin strong dollar policy, will not deny this. I’m personally skeptical about Dean’s maintained hypothesis that Clinton-Rubin policies had much impact on dollar demand, but I think there is a good case to be made that the Bush policies identified by the Times do have considerable impact. When a nation continues to run budget deficits in the face of a negative personal savings rate, there is a tendency for investors to lose confidence in that nation’s currency and to demand less of it at any given interest rate.

The difference in effect between a shift in the demand curve and a movement along the curve is important, though I don’t think the Times identifies that difference quite correctly, or at least the Times doesn’t make the true difference clear. The editorial implies that a shift in the currency demand curve is more inflationary than a movement along that curve. That may be true in the long run, but it's not obvious that it’s true in the short run. The true difference (assuming monetary policy is working well) is that, with a shift in the demand curve, the stimulus from the improved trade balance is offset by reduced domestic investment, whereas, with a movement along the curve (assuming that movement results from increased domestic savings), the stimulus is offset by reduced consumption. I think Greg and Dean will agree that the latter is preferable.

In the long run, less investment leads to a lower growth rate of productive capacity, which slows the rate of labor productivity growth, and much contemporary opinion holds that slowing productivity growth brings about an unfavorable shift in the Phillips curve, causing inflation to accelerate more rapidly (or decelerate less rapidly) at any given level of employment. Thus, in a sense the Times is right to argue that the “shift” strategy is inflationary (because it reduces investment). Perhaps the anticipation of such future inflationary conditions is what reduces the Fed’s “room to maneuver” in the face of a weakening currency. The Times doesn’t spell out this argument, but it makes some sense to me if that’s what they had in mind.


* In the model I have in mind, the quantity of dollars demanded depends on relative interest rates, and then the foreign exchange value of the dollar depends on the quantity demanded (as if the supply of dollars in the foreign exchange market were perfectly inelastic). The demand curve to which I refer represents the first relationship, and the value of the dollar is then determined by the second relationship. Obviously this is a simplification, since the bond markets and the foreign exchange market have to come into equilibrium simultaneously, and there really is not a perfectly inelastic supply of dollars. For purposes of the present analysis, however, I don’t think this simplification distorts the point I’m trying to make.

Aaaargh!!! (Slaughter on China)

Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized intervention? We’ve been through this before, but the latest case in point is Matthew Slaughter, writing in the Wall Street Journal (and cited uncritically by Greg Mankiw and Mark Thoma):

Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Under the standard paradigm, a central bank maintains a fixed exchange rate by adjusting interest rates so as to attract enough capital to keep its level of foreign reserves roughly constant. In the very short run, the level of reserves fluctuates, but if the central bank is truly trying “control one nominal price” with “sovereign monetary policy,” the level of reserves should not show a dramatic trend over time. As its level of foreign reserves increases, the central bank should recognize the increased demand for money and satisfy that demand by adding domestic reserves to the banking system. That’s the way “monetary policy” works.

What the People’s Bank of China is doing is something quite different. Even as it maintains its effective dollar peg, it is attempting to cool the economy by raising interest rates. It is not controlling “one nominal price”; rather, it is attempting (with limited success) to control two things at once. It is trying to keep exports strong by keeping the currency weak, and at the same time, it is trying to reduce domestic demand by tightening domestic monetary policy. As a result, it is accumulating a huge, huge, huge quantity of dollar-denominated assets, and this rate of accumulation is clear evidence of a policy conflict.

The conflict might be a bit more obvious if things were going in the other direction. If China were trying to peg the yuan too high rather than too low, while at the same time trying to stimulate, rather than cool, its domestic economy, it would be losing reserves rapidly. The process couldn’t continue, because it would run out of reserves. Then it would be forced either to abandon the peg or to tighten the domestic money supply dramatically. Because the process is now going in the opposite direction, there is no “crisis”, but otherwise what we are seeing is the exact inverse of conditions that would normally have led to a foreign exchange crisis. Of course, when a country does have a foreign exchange crisis, we don’t read economists saying that it is just “sovereign monetary policy” and nothing to worry about. When the process happens in reverse, though, apparently central banks can find plenty of apologists for their unsavory policies.

Don’t Just Float the Yuan

My earliest posts in this blog (see the archives from April and early May 2006) dealt largely with the subject of China’s artificially weak currency. The general thrust was that the weak-RMB policy was inefficient from a global point of view, contrary to China’s interest, and probably contrary to US interest as well despite the benefit to US consumers. Upon further thought, it seems to me that those posts stand in a somewhat ironic relation to my KNZN screen name. From a Keynesian point of view, if we take China’s other policies as given, allowing the yuan to appreciate seems like a distinctly bad idea for China and not necessarily a good one for the US.

By most accounts, the pace of capital investment in China is already so rapid as to be unhealthy. Meanwhile, despite some concerns about overheating, the inflation rate remains tame. So what would happen if China were to allow the yuan to appreciate? In terms of the components of national output, net exports would fall. There is no reason to expect a change in either consumption or government purchases. This means that China’s monetary authorities would face a choice: either push easy money to encourage increased private investment, or let national income fall (relative to its path under the current regime). If national income were to fall, standard Phillips curve theory suggests that the inflation rate would fall as well, possibly pushing China into an unpleasant deflation. Those possibilities don’t sound particularly pleasant.

There is also the possibility that “standard” Phillips curve theory doesn’t apply in this case. That is, China’s Phillips curve may be flat in its current range, so the result of an appreciation would be lower output at the same inflation rate. A flat Phillips curve is essentially a free lunch, so by advising China to allow appreciation without encouraging more rapid investment, we would be advising them to pass up the free lunch. Alternatively, maybe the Phillips curve is vertical, in which case deflation becomes the only alternative to more rapid investment in the case of an appreciation.

The US, on the other hand, is by most accounts (though not by mine) already near (if not at or above) full employment. By increasing net exports (which is to say, decreasing net imports), a stronger yuan would force the Fed to raise interest rates to discourage private investment, which is already not as strong as one might hope. (I’m assuming that the Fed agrees with the consensus and not with me, and since the US Phillips curve seems to be fairly flat right now, it will be a long time before the Fed – and the consensus – realizes its error. Alternatively, you can just assume that the consensus is right.)

So a good Keynesian ought not to advocate a mere floating of the yuan (unless of course that good Keynesian disagrees with the consensus that investment in China is currently too rapid). For China, a good Keynesian ought primarily to advocate a fiscal stimulus – lower taxes or more government spending, perhaps a publicly financed health insurance system that would reduce the need for precautionary saving by individuals. Once the fiscal stimulus is a done deal, it will hopefully be obvious to the Chinese that the currency needs to appreciate.

The Chinese Exchange Rate and US Borrowing

One cool thing about having my own blog is that I get to comment on Tyler Cowen even when he closes comments. (This is even better than bringing back deleted comments from Brad DeLong’s blog.)

Tyler Cowen argues against pushing for yuan revaluation on the grounds that revaluation would only tie the hands of the US:

The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility. I don't see how pressuring a more rapid change in one set of relative prices (namely U.S. vs. China), which are likely to change anyway, will cure that ailment in a significant way….

A key reason to be skeptical of yuan revaluation is that it tries to address a relative prices problem by shrinking the opportunity set facing the U.S. That is not obviously the right way to go. The point is not to claim that all elasticities are zero, but rather that a trade balance shift, through revaluation, really does require a loss of resources. What fact about the world would make that the best way to go?

What fact? Two words: sticky prices. Consider the four possibilities:

1. Weak yuan + US borrows


2. Strong yuan + US borrows


3. Weak yuan + US does not borrow


4. Strong yuan + US does not borrow

Which of these possibilities is optimal for the US? Tyler Cowen would probably choose #3, but he’s wrong. Not being a Keynesian, however, he won't appreciate why the correct answer is #4 (although Greg Mankiw should, so maybe he can tell me why I’m wrong).

Why not #3? Because if we choose what’s behind door #3, we get a huge and prolonged recession. A fiscal tightening, in the presence of a still-strong currency, will knock out the economy. (We kind of already tried that one back in 2000-2001. In that case the fiscal tightening came from the business sector, which continues to run a large surplus unto this very day. We have since had a recovery, a slow and painful one, brought about mostly by households and government, which are borrowing heavily, partly from China.) As long as China keeps our trade sector weak by keeping its currency weak, our optimal strategy is to borrow.

Furthermore, as long as the US is willing to borrow, it is in China’s interest (given the conservative preferences of its leaders) to keep its currency weak. If the US suddenly stopped borrowing, it would lower US interest rates and make dollars less attractive relative to yuan, forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise. As it is, the path of least resistance for China is to maintain the peg.

So there are two Nash equilibria, and we are stuck at the bad one. As long as the US borrows, it is optimal for China to peg. As long as China pegs, it is optimal for the US to borrow. Ultimately, both countries would be better off if the US stopped borrowing and China stopped pegging, but, as we say in Boston, you can’t get there from here.

I’m not sure how you get out of this bad equilibrium, but one possible way is by trying to change the preferences of China’s leaders, so that it will no longer be optimal for them to peg. I’m not sure how one goes about that, and Tyler Cowen may be right that political pressure is the wrong way, in which case I’ll concede the war but not the battle.

Not the End of the World

Now that we’re going to have a recession, the question arises as to how we are going to get out of it. “With great difficulty,” seems to be the consensus. Getting out of a recession is seldom easy, but I think some commentators have exaggerated the difficulties involved this time around. In particular, Brad DeLong (quoted by Mark Thoma) is pessimistic about the options the US would have available should it fall into a recession (for which he puts the odds at about 30%, although he doesn’t make much of a case for the remaining 70%). The rest of this post reproduces (on mvpy's suggestion) a comment I made on Mark Thoma’s entry above. First, citing Professor DeLong regarding the prospects for a monetary solution:

… sharp reductions in interest rates would lower the value of the dollar and increase inflationary pressures from import prices in a way that the Federal Reserve does not dare allow.

This is a controversial point, and Brad is going out on a bit of a limb here. First of all, many imports are priced in dollars, and many of those that aren’t literally so are effectively priced in dollars because the prices get adjusted according to the prices of dollar-priced competitors. Brad remembers as well as anyone how adamantly foreign producers tried to defend their US market shares during the dollar declines of the late 1980s.

Second, policymakers in foreign countries that depend on US demand or compete heavily with the US aren’t likely to allow dramatic appreciation in their currencies. The Asian countries just won’t let it happen. Europe may let it begin to happen, but when their economies start to decline due to US competition and their inflation rates decline due to a strong Euro, the ECB will ease up and allow the dollar to appreciate again (and, in fact, traders will anticipate this action and forestall a dramatic rise in the Euro to begin with). Moreover, the Fed will anticipate these foreign responses and therefore will not be tremendously concerned with the value of the dollar until they actually see the inflation rate rising because of it (which it may never do, for this and all the other reasons described here).

Third, with the US economy in recession, with the Fed’s inflation-fighting credibility high (as it will be, if the Fed manages to cause a recession), and with an extremely weak US labor market (much weaker, because of the recession, than the already very weak labor market today), there will be dramatic domestic disinflationary pressures to offset any inflationary pressure from imports.

Fourth, in the event of a US recession, those imports (such as oil) that have volatile prices will (along with everything else) experience a drop in demand, which will put downward pressure on prices and tend to offset the effect of the weak dollar.

Finally, to the extent that import prices do rise, and export prices fall in terms of foreign currencies, this will be an excellent stimulus for the US economy. Like any economic stimulus, a weak dollar also tends to be inflationary, but it is not reasonable to assume that its inflationary impact would be out of proportion with its stimulative impact. You wouldn’t say, “Sharp reductions in interest rates would increase demand for building materials and construction workers and thus produce inflationary pressures that the Fed doesn’t dare allow.” During a recession, the Fed does dare allow inflationary pressures, because they are offset by the disinflationary impact of the recession itself.

Central Bank Bond Purchases and US Interest Rates

Do bond purchases by the People’s Bank of China (or the Bank of Japan or SAMA or [fill in the blank]) lower US interest rates? Clearly “no” is not quite an acceptable answer, but the answer is not quite as much of a “yes” as many people think.

In the short run the Fed has a target for the short-term interest rate. If the PBoC buys Treasury bills, the Fed will sell enough Treasury bills to keep the interest rate essentially unchanged.

What about the long-term interest rate? Certainly it’s true that, if the PBoC makes, out of the blue, a decision to buy long-term bonds instead of bills, those purchases will tend to push down the long-term interest rate. But why would the PBoC make such a decision? Presumably for the same reason that a domestic bondholder might typically make such a decision: the difference between the long-term rate and expected short-term rates over the life of the long-term bond is big enough (and in the right direction) to compensate for the risk of holding a longer maturity asset. Is there any reason to think that the PBoC has different maturity preferences than a typical domestic US investor? If anything, the PBoC takes more risk than a domestic investor by extending maturities. If long-term rates are high enough to be attractive to the PBoC, they should be, if anything, even more attractive to a domestic investor, which means, if the PBoC weren’t there to buy, domestic investors would have provided the same demand, and the interest rate would be the same.

Of course, Chinese demand will affect the long-term interest rate if it affects the expected path of short-term interest rates. And it probably does, but the influence is not entirely straightforward. China’s bond purchases are a side effect of China’s dollar purchases, and the dollar purchases have the intended effect of strengthening the dollar. The strong dollar makes US exports less attractive and imports more attractive, which reduces the level of aggregate demand in the US economy, and, as a result, the Fed is ultimately likely to follow a looser monetary policy, so interest rates do go down.

So intervention by China (or Japan or Saudi Arabia or wherever) does have the net effect of reducing US interest rates. At any particular time, though, the effect of such intervention is likely to be swamped by the effects of other business cycle phenomena. For example, dollar purchases (and the attendant bond purchases) by foreign central banks increased dramatically between 2002 and 2005, but so did US interest rates. In 2002, the US was experiencing the effects of the tech bust; in 2005 the US was experiencing the effects of the housing boom. Intervention was a factor – probably pushing interest rates farther down in 2002 and keeping them from rising quite as high in 2005 (and 2006) – but it wasn’t the main part of the story. In general, if you want to find out what’s going to happen to US interest rates, foreign central bank intervention is not the thing to look at.

Is the budget deficit destabilizing?

Hoping to avoid a descent into fiscal silliness, I am looking for reasons to be against the budget deficit. One possible reason is that the deficit has destabilizing effects on the international economy. It is surely true, to the extent that the deficit props up the dollar against floating currencies like the euro, that it sets up the dollar for a more precipitous fall – with more troublesome and unpredictable consequences – in the future.

On the other hand, the deficit may have a stabilizing effect on countries that (like China) effectively peg to the dollar or (like Japan) often intervene to keep their currencies weak. By pushing up US interest rates and thus making dollars more attractive to private investors, the budget deficit reduces the number of excess dollars that countries like China and Japan need to absorb. This presumably decreases the risk that such countries will eventually provoke instability by changing their minds about their massive dollar holdings.

So the answer to the question in the title of this post is only “maybe.” While it seems unlikely that the deficit has a net stabilizing effect (at least in today’s rapidly growing world economy), it is not clear that it has a net destabilizing effect.

How the Budget Deficit Props Up the Dollar

In an earlier post about the deficit and the dollar, I admitted to “glossing over a lot of details.” I’ll never get all the details into one post, but here are a few more.

What would happen if Congress were to reduce the deficit, let’s say by canceling a bunch of bridges to nowhere? If I were in a hurry, I would say, “The government will borrow less, easing demand on credit markets and causing interest rates to fall.” But that statement is misleading. Short-term interest rates are determined by Fed policy, and long-term interest rates are determined largely by anticipation of future Fed policy. The deficit affects interest rates because it affects Fed policy. So what would really happen? First, many of the people who were supposed to build those bridges to nowhere would lose their jobs, or would not be hired in the first place. The Fed, being a forward-looking institution, would attempt offset the decline in employment by stimulating new employment, which it would do by cutting interest rates.

What happens when US interest rates go down? Among other things, the dollar becomes a less attractive currency, because it offers less interest. Consequently, investors try to exchange their dollars for other currencies. These attempts to exchange dollars present different problems for different countries, depending on whether their currencies are pegged to the dollar.

Consider first a pegged country, China. China will have three options, none of which it will be very happy with. First, it can cut its own interest rates so as to reduce the incentive to hold yuan and stem the tide of dollar exchanges. The problem with this option is that it would further encourage Chinese investment, which by most accounts is already too high, and it would run the risk of causing the Chinese economy to overheat and generate inflation. Second, it can simply accommodate the demand for yuan by increasing its own holding of dollars. The problem with this option is that the People’s Bank of China already has more dollars than it could possibly want. At some point it’s going to start worrying about the risk it takes by holding ever increasing numbers of dollars. The final option is to revalue the yuan. It’s probably not as likely as the other options, but if we want to put pressure on China to revalue, cutting the budget deficit is a good way to do it.

Now consider an unpegged country – well, not a country but a union – the EU. Since the EU doesn’t normally intervene in the foreign exchange market, it will initially allow the market to handle the dollar exodus by letting the value of the dollar drop against the euro. The drop in the dollar will decrease demand for European products relative to US products, and the ECB will attempt to offset this decrease in demand by cutting interest rates. But how far will it go? Will it go all the way and cut interest rates to the point where the dollar rises back to its initial level? Consider what would happen if it did. Europe’s trade balance would be the same as before, but its interest rate would be lower. Since the lower interest rate stimulates demand domestically, the overall level of demand would be higher, and the ECB would worry about inflation. Consequently, it will not allow this situation to occur. It will cut interest rates somewhat, but not enough to fully offset the effect of the US deficit cut on the exchange rate. Thus, in the end, because the budget deficit declined, the dollar falls against the euro.

Notice that any US “weak dollar policy” or “strong dollar policy” has no effect on these outcomes (unless such a policy means that the Fed is willing to override its employment and inflation objectives). In principle, it can’t. If the US as a nation is going to borrow less, then it must run a smaller trade deficit, and the only way to do so (aside from having a recession) is to drop the value of the dollar to make US goods and services more attractive. If the government reduces its borrowing, unless this decline is offset by an increase in private borrowing (or unless the Fed allows a recession to happen), the dollar must fall, regardless of whether the US has a “strong dollar policy.”

Don’t Blame Rubin

Things are back to normal: I disagree with Dean Baker. But there is still something not quite right. Usually he is the one more critical of the Bush administration. This time he seems to be the one defending Bush.

Baker argues that the New York Times is wrong to blame Bush’s budget deficits for the high level of US foreign indebtedness and its potentially destabilizing effects. The problem, he argues, is the strong dollar, and this, he contends, is not the result of the budget deficit. If any American is to blame, he suggests that (former Treasury Secretary) Robert Rubin is the man.

He’s wrong. (Ah, yes, that feels natural.) First of all, he’s wrong because Treasury policy has little to do with the value of the dollar anyhow. Granted, there are occasions when a strategically placed gust of hot air from the mouth of the Treasury Secretary can shift the winds of a volatile foreign exchange market, particularly if the gust is supported by well-timed intervention and cooperation from foreign authorities. And granted, the Treasury can exert a slight modicum of influence over monetary policy, at least in the short run, when it comes to the value of the dollar. All these mechanisms might have been operative in 1985, when the dollar made a dramatic shift in direction after the Plaza Accord. But ultimately, the subsequent weakness of the dollar depended on a loose monetary policy occasioned by the sudden drop in oil prices in early 1986, which reduced the inflation rate while causing a regional recession in the Southwest. (Interestingly, the rest of us seemed not to notice that recession. Here in the Northeast, I only became aware of it several years later when I was studying regional data for my thesis.) In any case, the Plaza Accord seems to be a unique event. There is no analogous reverse event in the 1990s that caused the dollar to strengthen. It was strong not because of US Treasury policy but because the US was perceived as a good place to invest.

Second, he’s wrong because a strong dollar in the 1990s was a good idea, whereas a strong dollar (or even a not-weak-enough dollar) today is a bad idea. In the 1990s, the capital inflows supporting the strong dollar were largely going to private investment (directly or indirectly). A weak dollar in those days would have either dried up that foreign investment or caused our economy to overheat. Today, the capital inflows are largely going to consumption. A weak dollar today, properly engineered, could be associated with a higher savings rate rather than less investment.

Finally, he’s wrong because the budget deficit is the reason for the strong dollar. If the US were not trying to borrow so much, dollar interest rates would be lower (relative to other currencies), there would be less incentive to hold dollars, and the value of the dollar would be lower against those currencies that don’t peg to it (including that of our largest historical trading partner, the UK). (I’m glossing over a lot of details here, but that’s the gist of it.)

When I think about what might happen (or what might have happened) to the world economy without the US deficit (and the strong dollar), though, I wonder if it’s really such a bad thing. But that’s a big topic, and this post is already too long.

Weak Yuan in the Long Run?

In a comment on an earlier post, reader mvpy points out that labor’s share of national income has a very robust tendency to revert to its mean over time. How, mvpy suggests, can I therefore argue that the weak yuan policy can have lasting effects on US income distribution?

The answer is, I can’t. Even on theoretical grounds, there is no reason (generally) to think that the weak yuan policy would have long-run effects on anything. (The exception – not accounted for in traditional theory – is path-dependence – the effect of the past on the future. For example, the weak yuan may make it profitable to build factories in China. If the yuan subsequently strengthens, but those factories have already been built, it may still be profitable to run them.)

Let’s be clear on this: exchange rates are a short-run phenomenon. In the long run, if China maintains the weak yuan, the strong demand in China will cause inflation, and the weak demand in the US will cause deflation (relatively speaking). The ultimate result is that it will no longer be cheaper to buy things in China than in the US. This phenomenon is known as “real appreciation,” and, in the long run, it renders exchange rate policy irrelevant.

The concern I have is that the long run may take a lot longer to arrive this time around. Ordinarily, when exchange rates are out of whack, it is because some country is trying to defend its currency at an unrealistically high value. To avoid running out of exchange reserves, that country has to tighten monetary policy, which has a deflationary impact and hastens the real depreciation of its currency.

China is in the opposite situation, and the picture is not symmetric. China does not have to worry about running out of reserves. Therefore, China can sterilize its foreign exchange intervention to blunt the inflationary impact. China need not follow a loose monetary policy, so the real appreciation may be a long time in coming. So (though again I hesitate to blame the low labor share in the US predominantly on China’s exchange rate) don’t be too surprised if labor’s share remains away from its mean for a lot longer than usual.