Monday, July 03, 2006

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.

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Anonymous Anonymous said...

"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"

I think not. The reason for the strong dollar is intervension on a grand scale by Asian central banks. Plus, they are not doing this in response to higher US interest rates (due to budget deficits), but are doing so regardless of rates of return, for domestic policy reasons. Simply, put your logic is misplaced; the Chinese would invest here irrespective of rates of return and, hence, irrespective of deficits.
Also, Japan had soaring deficits for years which were coincident with extremely low interest rates. On the whole, Rubinomics doesnt work in practice; its really that simple. Do "Dont Blame Bush".

Anyway. Happy July 4 and God bless America.

Tue Jul 04, 03:12:00 AM EDT  
Blogger knzn said...

It depends on to what extent the marginal intervention is sterilized.

If it is nonsterilized, then you are right. Then the PBoC is just monetizing the US debt, and increasing that debt does not increase the value of the dollar. The deficit is still potentially destabilizing, though, because it increases the amount of dollars on the PBoC’s balance sheet and thus increases the risk that China will balk at continuing to absorb dollars.

If the intervention is sterilized, then the deficit does increase the value of the dollar (assuming no Ricardian equivalence etc.). Sterilization means that China (for example) effectively borrows the money it uses to finance the US deficit, so the interest rate in China and the US still rises, and investors shift assets out of Euros (for example) into $/RMB. The financing for the US deficit has to come from somewhere, so if it’s not coming from Chinese seignorage, it’s coming from the capital markets.

On average, much of the intervention is nonsterilized, but I suspect that, on the margin, most of it is sterilized. China sterilizes when overheating becomes an issue, which is more likely to be the case for the marginal increase in intervention brought about by a larger US deficit.

Tue Jul 04, 04:29:00 PM EDT  
Blogger knzn said...

I take back what I said in the last comment. Even if China doesn’t sterilize, the US deficit raises the value of the dollar against floating currencies. China would be monetizing US debt anyhow; in fact, in order to peg to the dollar, it would have to monetize more US debt if the deficit were smaller. The deficit still raises the US interest rate and thereby attracts capital from floating-rate countries.

Think of the Mundell-Fleming model with fixed exchange rates. A fiscal expansion causes income to rise. The Fed will prevent this by (incipiently) raising interest rates, causing capital to flow to the US. In a fixed exchange rate world, a country facing an exogenous fiscal expansion would have to choose between overheating and revaluation. In the case of the US, it doesn’t revalue against China, but it avoids overheating because it can revalue (automatically) against Europe etc. Basically, if it weren’t for the deficit, the dollar would be much weaker even than it already is against the euro.

Tue Jul 04, 05:23:00 PM EDT  
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