Richard Baldwin: Is the United States Headed for Double Bubble Trouble?

Richard Baldwin says we still have reason to believe that Paul Krugman's Wile E. Coyote moment where there is a sudden plunge in the dollar "is in the offing":

Is the United States headed for double bubble trouble?, by Richard Baldwin, Vox EU: In the minds of most mainstream international economists, there is never much doubt that the dollar must eventually decline significantly.[1] A trade deficit this big cannot persist indefinitely. Many analysts hope that the necessary real depreciation of the dollar might be gradual. After all, isn't the avoidance of such jumps one of the reasons we abandoned  the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar?

Here is the basic idea underlying dollar 'plunge scenarios.' Foreign investors have long demonstrated an increased appetite for US assets, moving a greater share of their portfolios into dollars and thus generating large capital flow into the US. But the capital flows needed to maintain an increased dollar share are much smaller than those needed to achieve it. Thus, when investors reach their desired holdings, there will be a drop off in capital flows into the United States, leading to an abrupt decline in both the current account deficit and the value of the dollar.

Standard asset-price logic, however, argues against this sort of anticipated sudden depreciation. Investors should see it coming, and this will dampen their shift into dollars. Under the 'gradual scenario', the adjustment process is smoothed as dollar assets become more attractive while the greenback drops towards its sustainable level.

The asset-pricing logic is impeccable. The only reason to predict a sudden dollar plunge is if we believe today's capital flows are driven by investor myopia. That the markets are due for what Krugman calls a 'Wile E. Coyote' moment – a reference to the Warner Brothers' cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn't start falling until he looks down and realizes he's left solid ground. Up until this 'Wile E. Coyote' moment, his belief that he's on solid ground prevents him from falling. For investors in dollars, the 'Wile E. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path.[2]

What constitutes a feasible adjustment path?

The key criterion is that the dollar must fall quickly enough to avoid US external debt reaching an unsustainable level. A simple model of the relationship between the path of the exchange rate and the path of external debt can assist in assessing the likelihood that investors are naively chasing the Road Runner off the cliff. Glossing over many details, a 'generic' portfolio balance model of the exchange rate lets us evaluate investor expectations. See Krugman (2007) for a mathematical exposition.

In this simple model, the real exchange rate is a function of external debt and expected appreciation. External debt affects the portfolio balance – a larger net external debt requires foreigners to hold a larger share of US assets or Americans to hold a smaller share of foreign assets, so the dollar must be lower. Expected appreciation affects the portfolio composition – investors prefer a currency that is expected to appreciate in value.

The dynamic of debt accumulation, the other variable of interest, is driven by the exchange rate and the debt level. Since the US tends to hold real assets abroad while its liabilities are denominated in dollars, a real depreciation of the dollar raises the value of US external assets without increasing its liabilities. So dollar depreciation reduces net external debt. The debt level affects its own rate of change in two ways. On one side, higher net debt reduces net investment income. On the other side, the debt-GDP ratio tends to fall, other things equal, due to GDP growth with the size of this effect depending on the initial ratio. Which of the two effects dominates depends on whether the marginal rate of return on foreign debt is above or below the rate of GDP growth; this is not critical to the Krugman story.

Given these standard asset-markets dynamics – and assuming that investors are rational, and that the US external debt is below its long-run equilibrium level – the value of the dollar is held down by expectations of future decline. Forward-looking behaviour rules out a sudden plunge.

But are investors forward-looking? If we believe that there are limits to how high the debt-GDP ratio may realistically rise, then the debt level (and exchange rate) must converge to the long-run equilibrium rapidly enough to avoid exceeding that limit. US net external debt is about 20% of GDP. This ratio will continue to rise so long as the United States runs a large current account deficit. Its rate of change depends on the rate of real depreciation along the assumed equilibrium path – faster convergence implies a lower long-run net external debt.

By how much must the real dollar fall to reach long-run equilibrium? In principle, this is endogenous to the steady-state debt level. A reasonable lower bound on the necessary real depreciation is the decline that is sufficient to bring the US balance of payments on goods and services to zero. Obstfeld and Rogoff (2005) estimate that a real depreciation of around 35% would be required. This is unlikely to be a serious overestimate and certainly might be a serious underestimate.

Given the current debt level and the depreciation required, consider whether there is any rate of convergence that is consistent with both present market expectations and plausible long-run net external debt levels. A 5% convergence rate implies an initial rate of depreciation of 1.75% per year – 0.05 times the long-run depreciation of 35%. This results in an eventual net debt-GDP ratio of 118%, which would generally be considered excessive. A 10% rate of convergence implies an initial 3.5% real rate of depreciation and an eventual debt-GDP ratio of 58%, which would be high by historical standards but perhaps plausible given financial globalisation.

What all this means is that a realistic long-run adjustment path requires real depreciation at more than 2% annually, perhaps as high as 4%. Those are plausible rates – provided that investors are being compensated for the future depreciation by higher real returns on dollar investments. They are not. That's the catch.

As of April 2007, there was essentially no real interest rate differential between the dollar and euro, and only a 0.9% real differential against the yen. As interest rates dropped worldwide in reaction to the Subprime mess, the gaps will not change much and may even move in the wrong direction. Future real depreciation of 2-4% annually implies that foreign investors are buying US bonds offering low or even negative real rates of return. This strongly suggests investor myopia. If markets are not taking the dollar's future decline into account, then the world economy is not on a smooth adjustment path. There's a reasonable case that markets are headed for a Wile E. Coyote moment.

Moreover, the plunge may be larger than suggested thus far. The 35% depreciation target is a conservative estimate. Indeed, the significant secular downward trend in the real dollar – the fact that since 1975 the real dollar associated with any given level of trade deficit seems to have declined –suggests that the dollar has even further to fall.[3]

Darkish reasoning: how the Coyote can hover

While mainstream thinking asserts that that the US' big trade gap suggests that the dollar must fall, the dollar itself seemed impervious to such suggestions for years. The strong dollar lasted so long that economists started inventing logics to challenge the mainstream thinking. Four novel arguments are especially noteworthy as they posit structural reasons for why the US current account deficit, and hence the strong dollar, may be more sustainable than previously thought. They are: 1) a global savings glut, 2) privileged rates of return enjoyed by US investors, 3) a 'Bretton Woods II' regime, and 4) 'dark matter' in trade flow statistics. Let's address each in turn.

First, many economists, including Federal Reserve Chairman Ben Bernanke (2005), have argued that there is a global savings glut that helps to explain the US current account deficit. While high savings abroad could make a large, prolonged deficit economically sensible, the net indebtedness of the United States must eventually stabilise, necessitating an inevitable real decline in the dollar. If investors anticipate this, then there ought to be a real interest differential between the United States and other countries to compensate them for the eventual real depreciation. There is not.

A second objection might rely on the fact that US investors earn substantially higher rates of return abroad than foreign investors in the United States. If this return differential is real and permanent, then it reflects what Gourinchas and Rey (2005) call – following De Gaulle's oratorical flourish – an 'exorbitant privilege.' But such a privilege is easily incorporated into the thought experiment above. First, it might cause GDP growth to exceed the marginal rate of return on foreign debt, dampening the impact of debt build-up on the adjusted current account. Second, it would modify the estimate of the debt-GDP ratio's initial rate of change, as the rate of debt accumulation would be further below the deficit on goods and services. Nonetheless, investor expectations remain far from a feasible path. The third novel argument, put forth by Dooley, Folkerts-Landau and Garber (2003), says the international monetary order has entered a 'Bretton Woods II' era, in which many central banks, mostly Asian, buy dollars to maintain nearly fixed exchange rates. Thus, despite a low rate of return, dollars will flow into the United States so long as central banks believe they need dollar assets. However, if this bank activity ran contrary to private expectations of real depreciation, we would see private capital outflows at least partly offsetting official capital inflows. But there is significant private inflow, so Bretton Woods II cannot explain the puzzling fact that private investors seem happy to buy dollar assets, despite a very modest real return differential that is overwhelmed by reasonable estimates of the rate at which the dollar must fall.

Finally, Hausmann and Sturzenegger (2007) explain the sustainability of substantial international imbalances with 'dark matter.' It's all down to Mark Twain's third-type of lie – statistics. Official statistics, the story goes, drastically understate the assets US investors hold overseas by omitting US-based multinationals' exports of hidden assets such as expertise and reputation. However, the puzzling combination of a roughly zero US investment income balance and a negative US net investment position seems to reflect low returns on foreign investment in the United States rather than high returns abroad. This implies that the 'dark matter' is foreign firms bringing bad reputations to US markets, which seems unlikely. Moreover, dark matter could only alleviate the need for dollar depreciation if it were rapidly increasing, as its level does not counterbalance the large current account deficit. While it is easy to imagine that many US foreign assets are undercounted, it is much more difficult to argue that such 'dark matter' is growing.

Therefore we still have reason to believe that a Wile E. Coyote moment is in the offing. Though it's always dangerous to second-guess markets, the data do seem to suggest myopia, and none of the various explanations of the US current account deficit advanced in recent years ease the difficulty of reconciling the willingness of investors to hold dollar assets enjoying only a tiny real interest differential with the size of the apparently inevitable dollar decline.

In February 2007, Krugman wrote that we seem due for a discrete drop in the dollar. That is looking pretty good at the moment. How much the fall will hurt depends on other things. He wrote in February that a dollar plunge is potentially frightening if it is coupled with a collapse of the housing bubble, but it is unlikely to be disastrous. In the medium-run, a contraction exacerbated by dollar depreciation will be offset by greater net exports. Still, a dollar plunge, by heading off what might otherwise be a substantial fall in long-term interest rates, may extend and deepen a housing-induced slump, as well as reduce the Fed's leverage over the economy. That would be 'double bubble trouble' and it probably won't be much fun.

References

Bernanke, B. (2005). 'The global savings glut and the U.S. current account deficit'. Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia.
Dooley, M., D. Folkerts-Landau, and P. Garber (2003). 'An essay on the revived Bretton Woods system', NBER Working Paper No. 9971.
Gourinchas, P. and H. Rey (2007), 'From world banker to world venture capitalist: U.S. external adjustment: the exorbitant privilege', in R. Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, The University of Chicago Press, 11–55.
Hausmann, R. and F. Sturzenegger (2007). 'The missing dark matter in the wealth of nations and its implications for global imbalances', Economic Policy, 51, 469–518.
Krugman, P. (2007). 'Will There Be a Dollar Crisis?', Economic Policy, No. 51, 435-467.
Obstfeld, M. and K. Rogoff (2005). 'Global current account imbalances and exchange rate adjustments', Brookings Papers on Economic Activity, 1, 67–123.

---

Footnotes

[1] Krugman presented the first draft of the paper on which I have based this column in February 2007 at the Economic Policy panel held in New York.
[2] The famous cartoon, see [here].
[3] For an early analysis of this problem see Krugman and Baldwin, "The Persistence of the US Trade Deficit", Brookings Papers on Economic Activity, 1:1987, p. 1-43.

Comments

[save_the_rustbelt]

Those of you who know a lot more economics than me....

What is the immediate impact of a major dollar decline on Joe Sixpack and Sally Middleclass?

Thanks for the info.

[Peter Schaeffer]

STRB,

Depends on where they work. If they are employed in export oriented production, it is likely to be positive. Otherwise the impact of higher import prices and higher prices for exportable goods is likely to be negative. Roughly Boeing wins and Wal*Mart looses.

[Free the Market]

If the Fed does its job right, there should be minimal impact on the CPI and employment rates. Import prices may go up, but the Fed will balance it by keeping domestic prices going up slower than when import prices were falling. A non event, unless you take a trip overseas. A potentially positive event if you invest in unhedged foreign assets.

[Bamboo Bob]

At the very least, the dollar weakness does seem to be helping to direct labor flows-- originally from the Eurozone and other countries to the USA, but now increasingly from North America (as well as Australia and NZ) to countries that use the Euro.

While the Eurozone is expensive to visit, it's a dream to work in these days, for anyone with the requisite professional background, mobility and of course the pertinent language skills-- German, French, probably Dutch may be most useful, though Italian and Danish may also come in handy depending on the sector one wants to work in. (I wouldn't be going to the UK though, bank collapses and big-time consumer debt aren't exactly great advertisements for the place).

I've certainly been noticing a steadily increasing trickle of North Americans to the Eurozone to work and even to permanently settle-- the schools there are great, cities very inviting, in general quite attractive to the professional class. But it's not yet a deluge, I'm not sure it'll get that severe, unless we do have that Wile E. Coyote moment.

[calmo]

I don't know if I can take being excluded like that from/by Rusty, you know?Those of you who know a lot more economics than me....There might be a moment when I do know more (there it went...missed it. Dang.) but much more likely, I could provide the background cover which might make those who are genuinely more knowledgeable, shine through.
So, not to be excluded, here is that cover: Either wages are driving or driven (fuggedabout "stagnant" or "increasing" and look at the power distribution: can you demand a higher wage or do you understand that your place can be taken by many others on the bench?) [You figure that is too black and white, that I didn't leave room for that grey area: "negotiations"? Ok, the night sky is not dark either --there are points of light.]
Wait, wait, I'm not done yet: Winslow feeds me this line (not exactly recognized as The Truth...yet, but hey I'm doin the best I can to fix that, right?) about the problem of over-production breeding deflation. So when Joe and Sally don't have the money (skip the liquidity) due to not having the power to increase wages and the capacity to pay for the goods/services they provide, prices fall...and so profits...and so unemployment rises...driving down wages further.
Anyhow...(see I leave room for Winnie to shine through) with the sinking dollar we have put this Race to the Bottom into a higher gear.

[AccruedInterest]

Isn't it possible that the real rate on U.S. bonds rise, thus attracting assets and offsetting the required dollar decline? In other words, if the dollar declines and causes some degree of pass-through inflation, the Fed would likely react by tightening monetary policy. In turn, this should attract foreign flows and make the trade deficit more manageable.

To me the best argument for a "required" dollar decline is the lack of any sizeable interest rate differential between Europe, Japan, and the U.S. So its illogical for the U.S. to forever get the lion's share of foreign flows, central bank or otherwise.

But by that argument, the reversal could be relative rates rising in the U.S. vs. ROW.

[Peter Schaeffer]

The author (Richard Baldwin) wrote

“However, if this bank activity ran contrary to private expectations of real depreciation, we would see private capital outflows at least partly offsetting official capital inflows. But there is significant private inflow, so Bretton Woods II cannot explain the puzzling fact that private investors seem happy to buy dollar assets, despite a very modest real return differential that is overwhelmed by reasonable estimates of the rate at which the dollar must fall.”

This is apparently not true anymore. See the most recent post by Brad Setser “Central banks came close to financing the entire US current account deficit over the past four quarters” (http://www.rgemonitor.com/blog/setser/217776)

“I have been reserve-obsessed for quite some time now. The uphill flow of funds from the emerging economies to advanced economies strikes me as the defining feature of today's global economy. That flow is entirely a central bank and sovereign wealth fund flow.”

“Private flows still matter, of course. But right now private inflows roughly match private outflows, so all the heavy lifting required to finance the US external deficit is being done by the world's central banks.”

[Ekaf Enam]

Ok, so here is a question that has been bugging me for a while...

What if you did believe that a large further fall in the dollar was indeed in the offing... Where would you invest?

Investing in foreign stock (large or small) does not seem very promising... The fall in $ would make foreign companies' products less competitive - particularly if they are export driven, and trouble in the American economy would surely 'contaminate' others.

Investing in export focused American companies might be good, but what you might gain in the stock appreciation, you'd likely lose in currency depreciation.

So, maybe I can buy some foreign bond mutual funds - but I think those are hedged against currency fluctuations, (right?!) so that does not help. You could go with foreign currency ETFs - those are certainly not hedged. But that seems much worse than just buying a bunch of Euros and sticking under your matress - for one you need to pay some small fee (<1%) for someone to just hold the currency for you... much worse, any gains you make are taxed as a capital gain (correct?) If I had just changed $1000 into Euros, I'd be much better off - no fee, no tax on appreciation.

But just sticking money under the matress can't be the best answer, can it?! I know, I could buy gold - but my bet is merely that the $ is going down, I don't want to start speculating in specific currencies (are there vehicles for investing in a broad basket of commodities?)

The last thing I can think of, would be a bearish $ ETF - like UDN. That would fit the bill, but again seems a bit speculative. What do others do?!?

[Farrar Richardson]

Thanks Peter S, I was just about to refer to Brad's post myself. Since central banks are buying up all or most of the Dollars resulting from the US trade deficit, it seems to me that we are not likely to be hit with a Wile E. Coyote moment, at least not in the near future.

Why not?

Because central banks don't manage their foreign currency holdings like investors do. A central bank isn't in business to earn a profit, so even if it suffers a book loss in its own currency through Dollar devaluation, what difference should that make? From what I hear, international trade is still invoiced in Dollars, and Dollar prices of manufactured goods are "sticky", which means that central banks' Dollar Reserves lose value only slowly. Commodities are a different story, but this is not the central banks' problem. Commodity importers, or course have every incentive to make forward contracts for their expected commodity needs.

If we have a real crisis in confidence, and exporters start demanding payment in Euros (or other currencies), then central banks would be obliged to follow, and then we would have a real problem, IMKHO.

[Farrar Richardson]

@Fake Name,

You might try An unhedged foreign govt bond ETF like GIM. Dividends about the same as US govt bonds.

[Ekaf Enam]

Thanks for the tip Farrar!

Though, am I correct that with such an investment I'd be effectively paying taxes on the appreciation due to currency appreciation. And if I just bought a bunch of Euros, I'd be missing out on the dividends but not paying taxes on the capital appreciation?

[anne]

Duh; have we bothered to look to relative investment returns through these several years of dollar weakness? What about looking to periods of past dollar weakness? That might suggest the analysis is wrong. Then too, have we bothered to figure out where present relative value is?

Knowing about the past and learning of present value can give more than enough of a sense of what may be expected. Also, when we are not professional investors we need to know that we cannot compete with professionals but we can think effectively and simply nonetheless and be compteitive as heck.

[Ed]

I always thought financial markets were reasonably efficient. So if everybody knows that the US dollar is heading for a huge fall market participants should have already acted on this information, shouldn't they? In fact for the last five years every financial planner that I know of has been reccomending foregin exposure to his/her clients. Ditto foreign stocks and currencies have skyrocketed during this period of time. Perhaps the Wile E. Coyote moment is already behind us.

[Farrar Richardson]

Anne, I'm sure your advice is good, but (sigh) you're making us do all the work.

OK, I'll throw these out and see if anyone likes them.

We are told a recession is close, and to buy consumer staples.
We are also told the Dollar will continue down, and to buy foreigh exposure.
So, being very clever and careful, we buy consumer staples with foreign exposure.
Proctor and Gamble
Colgate Palmolive
Coca Cola
Pepsico
All substantially represented in the Vanguard Consumer staples ETF

Or even more foreign -
Nestle
Diageo
Cadbury Schweppes

Or we might think luxury goods and booze always do well and buy
Louis Vuitton, Moet Hennessy

Or being more optimistic, agressive and far-sighted, we might go for commodities, which will require more study before I throw out any names.

Anyway, don't take my advice, I'm still poor.

[anne]

Sorry sorry; the point of stock and currency value changes over and again is that stock values change with lags but in line with currency value changes, only with a nice catch. While losses in currency value are compensated with a lag by stocks, so gains in currency value are for a considerable time at least matched by stock gains. The trick seems to be whether currency value gains are allowed to lead to recessions, where there is a loss in stock value in time.

The rule for bonds, as French and British bankers should have known is the risk in unhedged international bonds is not worth the possible returns. There is speculative value, but that is for professionals, and institutions may need to hold fixed duration bond positions indefinitely, but that is different.

As for currency speculation, I never ever think I can compete with professionals and currency speculation is for professionals.

[anne]

I have no idea whatsoever about currency direction from here, but a single Vanguard fund would have allowed for diversification and long term safety and hedge fund type gains, with you being the hedge fund and among the best hedge funds, these last 5 years.

The Europe Index has averaged gains of 25.5% a year these 5 years. From here I have no idea, because the relative value of the Index in Euros is a whole lot less now than 5 years ago. But, the idea is to think value and think ahear, far ahead, and never bet against professionals by timing investments.

[anne]

I would not be surprised if there were a dollar value increase, nor the reverse from here, but this movement was already set in 2002 and it is almost 2008, and there has been an astonishing international investment boom somewise beyond comforting valuations. I am content being awfully conservative from here.

[Peter Schaeffer]

STRB,

Here is Dean Baker on the dollar "The High Dollar: The Real Cause of the Weak Dollar" (http://tinyurl.com/yor6hm)

"The reality is that the high dollar policy initiated by Robert Rubin in the Clinton presidency was a short-term policy that temporarily allowed for higher U.S. living standards by making cheap imports available. (It also had important distributional effects, depressing the wages of less-educated manufacturing workers who are subject to international competition, while raising the real wages of highly educated professionals, who are largely protected from competition.) However, the trade deficit that resulted from the high dollar was unsustainable over the long-term, just as a large budget deficit is unsustainable. The Clinton-Rubin high dollar policy is to blame for the current decline in the dollar, not President Bush's tax cuts."

Strangely, Dean Baker may be a bit too hard on Clinton/Rubin and is too easy on Bush. Some folks argue, that at least early on, Clinton favored a low dollar (and the dollar was low). Bush has clearly favored a high dollar, irrespective of the negative consequences.

[Peter Schaeffer]

Farrar Richardson,

“If we have a real crisis in confidence, and exporters start demanding payment in Euros (or other currencies), then central banks would be obliged to follow, and then we would have a real problem, IMKHO.”

I don’t see how the currency of payment makes any difference at all. Buyers and sellers can swap dollars for Euros, and vice versa now, in essentially unlimited quantities. Stated differently, if sellers demanded Euros, dollars buyers could either swap dollars for Euros one instant before payment or they could just pay in dollars and let the sellers do the swap one instant later.

What currency buyers and sellers choose to hold assets in could make a large difference. Of course, the currency of choice for central bank reserves is even more important. However, this has little to do with the currency of payment. Right now the oil states hold most of there reserves in dollars even though they trade more with Europe and Asia than the US. The implied linkage doesn’t exist.

[prostratedragon]

WEC is a flow argument, not a stock argument, I think; must read it again at least once, later. But Setser comments in his post:

A Wile E Coyote moment only requires that EMs not increase their dollar demand when private demand for $ (net private demand -- a fall could either come from a fall in inflows or an increase in outflows). It every just stopped adding to their reserves and the share didn't change, the $ would tank. The key to recent stability has been the willingness of CBs to both add to their reserves AND to hold the $ share constant, which implies rapid growth in their $ holdings. you need both conditions to hold to keep the system stable.

My emphasis. To willingness, add capability, especially where the emerging market cbanks are concerned; they can't necessarily keep buying $ forever, however much they might want to. And, as I also thought I was reading from Baldwin, all that would be necessary would be for private outflows to outpace cb inflows. Wile E. could still be up in the air, despite the known data, I think.

[anne]

Yes; no question, the end of the world is come or coming, only I thought that was come 18 months ago according to Nouriel Roubini. The dollar goes up and the dollar comes down, but all will be well and I will be able to buy French cheese. Paul Krugman, who is as good as they get, was writing with apologies of the coming end for the dollar in Martch 2000.

[Farrar Richardson]

@Peter S

"I don’t see how the currency of payment makes any difference at all. Buyers and sellers can swap dollars for Euros, and vice versa now, in essentially unlimited quantities. Stated differently, if sellers demanded Euros, dollars buyers could either swap dollars for Euros one instant before payment...."

Agreed.

I was reasoning from the premise that central banks are more or less covering the US current account deficit as noted by Brad Setser.

Going on from there, it appears to me (maybe I'm wrong) that if central banks hold currencies in amounts proportional to their countries 'expected expenditures in those currencies they risk less REAL loss due to the fluctuation in value of the FX reserves that they hold.

Thus, in my opinion, the Saudis risk substantial loss in the REAL value of their reserves (in fact they may have already suffered such losses)since they have been holding too much in Dollars. Thus, if importers' (or investors) wish to buy Euros from the Saudi National Commercial Bank, and they in turn from SAMA, and SAMA in turn from their correspondents, SAMA will have to spend more Dollars than if they had bought those Euros six months ago. These transactions don't show up as book losses - I guess you would call them opportunity costs. But they could easily foresee them.

Here, there is some danger of a Wile E. Coyote moment, if they should decide to switch massively from Dollars to Euros, Yen, etc.

On the other hand, if SAMA simply revalues the Riyal, there is no REAL loss at that moment - just a book loss.

Of course, If the importers are smart, they will hedge Euro purchases well in advance, as will the banks, which will reduce the risk all around.

[Farrar Richardson]

Yes, I believe the Dollar will recover in the long run, but we all know what Keynes said about the long run

The Dollar recovered rather quickly from the last period of weakness, but this time, the situation is much different.

[anne]

Imagine how little I care; I will still be eating French cheese a year from now and a year from then. American investors have been discounting the change for the last 7 years. All that really matters is avoiding a recession, and that is what the Federal Reserve will be concerned with.

[Farrar Richardson]

@prostrate d
"...they can't necessarily keep buying $ forever, however much they might want to..."

Why can't they? As long as they can print their own currencies, they can continue to buy from their exporters. In fact, they more or less have to, politically.

I maintain that the real danger is a big change in the composition of CB reserves in EMs including BRICs and petro states..

Or perhaps a flight from the Dollar on the part of investors.
But in that case the CBs in refuge countries would support as much as they could. I guess this is what prostratedragon is talking about, but EM countries are not likely to be refuges for flight capital.

[prostratedragon]

Why can't they? As long as they can print their own currencies,

But I don't think they get to do all that printing, while keeping the paper exchangeable for dollars, indefinitely. At least, so an Argentine acquaintance once told me.

Maybe not even China.

[Farrar Richardson]

@Anne -

I couldn't care less either. I'll be down in the hot place toasting grilled cheese sandwiches

[Farrar Richardson]

@Fake Name -

Pay your taxes cheerfully to support George bush's war. After all, he's given you a break on capital gains.

[bill mccullam]

Is there perhaps a greater differential in rates of return if we consider that returns on foreign debt in the US is not subject to withholding tax; whereas all other debt outside the US is subject to witholding tax at rates varying from 15-37%?

[paine]

i think the role of central banks is abstracted away here

"despite a low rate of return, dollars will flow into the United States so long as central banks believe they need dollar assets. However, if this bank activity ran contrary to private expectations of real depreciation, we would see private capital outflows at least partly offsetting official capital inflows"

follow this logic

if the asian/oiler CBs will effectively
do what is necessary to prop the imperial dollar
against their own currencies
where can the flow out go ???

the euro ??
the yen ???
the pound ???

none of these northern giants
have underlying economies
protected from the asian trade onslaught
much deeper then uncle sam's amerika has

the dynamics of the dollar peg

forces the yen euro etc CBs
to more or less prop the dollar too

they are all captives of the dollar's exchange value
short of national trade barriers

[Farrar Richardson]

Yeah, I suppose you're right, Paine. After all, if the Saudis want to convert reserves to Euros, they will wind up buying them from the ECB (even if indirectly) by selling Dollars. So the ECB is put in a position where it almost has to support the Dollar.

[paine]

fr

my god someone bright actually
agrees with me
about
the way it all works

but then even rogoff in above post
is coming around