Economist's View

"A Chinese Conspiracy Theory"

Andrew Leonard at Salon sums up recent commentary on Chinese investments in U.S. bonds that is going sour, and provides some of his own:

A Chinese conspiracy theory, Andrew Leonard: Hardly a day goes by without Dean Baker finding something to get angry about in the pages of the New York Times or Washington Post, but on Friday morning the co-director of the Center for Economic and Policy Research delivered a double-dose of dyspeptic sputtering.

"Is China's Central Bank Run By Morons?" asks Baker, responding to a Times piece detailing the woes of the People's Bank of China, which has found itself stuck with a gargantuan pile of U.S. bonds that are turning out to be a pretty bad investment.

Baker can't understand how anyone could have been stupid enough, back in 2001 or 2002, not to foresee that the then mighty dollar would inevitably decline, given the size of the U.S. trade deficit. If the Times' Keith Bradsher was reporting accurately, argues Baker, when he quoted an expert in Chinese financial affairs as saying that many bank officials "resented the institution's losses," then the Times misjudged the importance of the story.

If the people who run China's central bank are really this ignorant, that should have been the headline of the article, which should have been on the front page.

I think Baker is overstating the case to declare that "Apart from buying bonds from Zimbabwe, it's hard to imagine how [the Chinese] could have made a worse investment." After all, if the Chinese hadn't been bailing out the U.S. financial system, where would the U.S. have gotten the money to pay for all the Chinese-made goods whose export has fueled China's economic rise?

To me, the most interesting tidbit in Bradsher's story was a reference to a conspiracy theory currently all the rage in China.

From the Times:

[The expert] said the officials blamed the United States and believed the controversial assertions set forth in the book "Currency War," a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

"A lot of policy makers in China, at least midlevel policy makers, believe this," Mr. Shih said.

That nugget reminded me of a line from a long, if not particularly interesting or insightful essay about Chinese-U.S. relations by Treasury Secretary Hank Paulson in the current Foreign Affairs.

Despite the two countries' long history of interaction, they frequently display a stunning ability to misunderstand each other.

Seriously; the officials at the People's Bank of China probably aren't morons, but they do betray a breathtaking misunderstanding of the quality of recent government in the United States if they think we could intentionally pull off that kind of massive grifter's scam on China. We're not worthy.

Another line from Paulson's essay is apropos here:

Exploiting popular anxieties about globalization, economic nationalists in China are questioning the benefits of China's integration into the international economic system.

That sentence also holds true if one substitutes the words "United States" for "China." Both nations boast sizable factions who believe the other side is taking advantage of them. I don't normally find myself in Paulson's camp, but I've got to agree with him on this one -- the U.S. and China are not playing a zero-sum game. China's bankrolling of U.S. debt has been critical to the stability of the U.S. economy and the U.S. appetite for Chinese goods has translated into increased prosperity for hundreds of millions of Chinese.

That's not necessarily a bad thing.

Brad Setser comments here.

The Most Attractive of Them All?

One explanation for the persistence of the current account deficit is that US assets are "unusually attractive." Are they?:

Are US assets special in the eyes of global investors?, by Steven B. Kamin, Vox EU: In principle, we would expect a mature industrial economy such as the US, with high incomes and large accumulated endowments of capital, to be running a current account surplus, exporting capital to much less developed regions of the world such as China or Malaysia. Not so.

In practice, the US has been spending far more on imported goods and services than it earns, financing a shortfall of some 5% of GDP with substantial borrowings from foreigners around the globe. A small cottage industry has emerged within the international economics profession to explain this apparent anomaly. Economists have put forward a wide range of explanations:

• US budget deficits;
• the collapse of US private saving;
• rising oil prices;
• the boom in US productivity growth;
• lingering effects of the Asian financial crisis; and
• persistent intervention by many developing economies to keep their currencies competitive.

US assets as unusually attractive

In the past several years, a new explanation has been enjoying increasing prominence.

Summers: The Global Consensus on Trade is Unravelling

Larry Summers says international economic policy is receiving too little attention in the presidential election. The success of the next administration and the fate of the US economy may depend upon the next administration's abilities abilities in this area:

The global consensus on trade is unravelling, by Lawrence Summers, Commentary, Financial Times: ...US international economic policy is receiving less attention in this presidential election year than usual. ... That is unfortunate. The next administration faces the prospect of having to make the most consequential international economic policy choices in a generation at a time when the confidence ... in free markets is being increasingly questioned.

The current distribution of regional economic power is unlike anything that was predicted even a decade ago. The rise of the developing world ... is ... a ... surprise... [W]ith almost all the industrial world in or near recession, much of the momentum in the global economy is coming from countries with authoritarian governments that are pursuing economic strategies directed towards wealth accumulation and building up geopolitical strength rather than improving living standards for their populations. China, where household consumption has now fallen below 40 per cent of its gross domestic product – which must be some kind of peacetime record – is the most extreme example. Similar tendencies, however, can be seen in other parts of Asia, Russia and other oil exporting countries. ...

For all the disagreements over the past decades, there has been a shared premise behind international economic policy discussions – the goal of increased economic integration, the spread of market institutions and more rapid growth for all nations. While companies may compete, the premise has been that nations co-operate to build a stronger economy in the interests of all.

It is no longer clear that this premise remains valid. Nations are increasingly preoccupied with their relative economic standing, not the living standards of citizens. Issues of strategic leverage and vulnerability now play a bigger role in economic policy discussions.

At the same time, it is unclear which underlying driver of global growth will replace the one in place for the past decade – the US as importer of last resort. Global growth has depended on US growth, which has depended on the US consumer; and the US consumer has depended on rising asset values first of stocks and more recently of real estate. With falling house prices and a challenged financial system, US consumer spending is falling. The US is no longer in a position to be a net source of demand for the rest of the world. ... Already, Europe and Japan are in or are very close to being in recession.

The current global policy debate is a cacophony. It is all very well to advocate increased US saving and a cut in the US current account deficit but the process for bringing it about will mean less US demand for foreign products. That will put pressure on jobs and output growth in other countries if no countervailing measures are put in place. Conversely, the return of a stronger dollar without other policy changes will raise US demand for exports but at the price of cutting demand for domestically produced goods and compounding the recession.

These problems ... may not be at the top of anyone’s agenda right now. But the success of the next administration could depend on its ability to engage with a wider range of global economic stakeholders, on a broader agenda, at a time when disagreements are increasing not just about means but also about ultimate ends.

"Capital Account Liberalisation: New Thoughts"

Now that ten years have passed since the Asian financial crisis, what have we learned about capital account liberalization? Eswar Prasad and Raghuram Rajan look at research on this question:

Capital account liberalisation: New thoughts on an old topic, by Eswar Prasad and Raghuram Rajan, Vox EU: It was fashionable in the mid-1990s for mainstream economists of nearly all stripes to recommend capital account liberalisation as an essential step in the process of economic development. Indeed, in September 1997, the governing body of the International Monetary Fund sought to make “the liberalisation of capital movements one of the purposes of the IMF and extend, as needed, the IMF’s jurisdiction …regarding the liberalisation of such movements.” The East Asian financial crisis of the late 1990s, where even seemingly well-managed countries like South Korea were engulfed by massive capital outflows and tremendous currency volatility, raised questions about the wisdom of developing countries opening their capital accounts, and certainly ended all discussion about giving multilateral organisations more of a mandate to push for liberalisation.

Ten years have passed and it is worth re-examining the benefits of openness to international financial flows, now that time has quelled passions and intervening research can shed more light on the debate. Moreover, the increasing desire of investors to look beyond their national borders for higher returns and diversification, as well as the increasing asymmetry in cross-border trade flows, necessitating corresponding financing flows, suggest that this is a particularly apt time to reconsider the issue.[1]

FRB Dallas: Why Are Exchange Rates So Difficult to Predict?

This Economic Letter from the Dallas Fed discusses the relationship between exchange rates and economic fundamentals. Can fundamentals predict exchange rate movements? It depends upon how the question is asked, e.g. how far into the future the forecasts extend, but it doesn't look promising.

What about the other way around, can exchange rate movements be used to predict economic fundamentals? The answer here is a bit more positive as there is some evidence that exchange rates are useful in forecasting commodity prices (an NBER Digest on this point follows the Economic Letter):

Why Are Exchange Rates So Difficult to Predict?, by Jian Wang, Economic Letter, Federal Reserve Bank of Dallas: The U.S. dollar has been losing value against several major currencies this decade. Since 2001–02, the U.S. currency has fallen about 50 percent against the euro, 40 percent against the Canadian dollar and 30 percent against the British pound (Chart 1).

These steep, prolonged depreciations have brought a new urgency to understanding the factors that move exchange rates. Some way of forecasting them would allow businesses, investors and others to make better, more-informed decisions. Unfortunately, exchange rates are very difficult, if not impossible, to predict—at least over short to medium time horizons.

Economic differences between countries—in such areas as national income, money growth, inflation and trade balances—have long been considered critical determinants of currency values.[1] However, there’s no definitive evidence that any economic variable can forecast exchange rates for currencies of nations with similar inflation rates.

Economists continue to seek the keys to predicting currency values. Some recent research supports the idea that exchange rates behave like financial assets, whose price movements are primarily driven by changes in expectations about future economic fundamentals, rather than by changes in current ones. These studies suggest that the real contribution of standard exchange rate models may not lie in their ability to forecast currency values. Instead, the models imply predictability runs in the opposite direction: Exchange rates can help forecast economic fundamentals.

Fed Watch: Follow the Money

Tim Duy syas if you want to understand what's going on in the economy, then "follow the money and see where it leads":

Follow the Money, by Tim Duy: My apologies to Brad Setser for borrowing the title of his blog for the evening.

I am writing tonight while on vacation at a cabin in Central Oregon. I do not have high speed internet access, reverting instead to a telephone modem. Consequently, I have left out some links that I would normally include. Not exactly my most polished piece either. And I probably shouldn’t even be working; it is just my son and me tonight, and he went to bed hours ago. A wise man would have followed and taken the rare opportunity for extended sleep, but I had some stories I just could not get out of my head, so better just to write them down.

During my brief stint at the US Treasury, an economist visiting from Australia requested an informational meeting with some Treasury staff to discuss the results of a paper he was in the process of writing. I recall this visit occurring during the height of the Asian Financial Crisis, about the time that JP Morgan issued a US recession call on the basis of an expected widening of the trade deficit. This economist, whose name I can’t recall, said that a US recession was simply not going to happen. Instead, he predicted that a wave of capital would flow out of Asia to the US, pushing down long term interest rates, which the Fed would accommodate at the short end. The end result would, he anticipated, be highly stimulative.

Not exactly conventional wisdom at the time, but needless to say, this turned out to be a remarkably accurate prediction; the capital flow into the US found traction in the already smoldering information technology sector. The rest is history, both good and bad. The lesson I took away from this episode was to drop your preconceived ideas about what you were sure would happen and just follow the money and see where it leads.

Sovereign Debt Risk

Something else to worry about?:

Watch Out for Sovereign Debt Risk, by Carmen M. Reinhart and Kenneth Rogoff, Commentary, WSJ: Optimists say that emerging-market defaults are a thing of the past. Emerging markets today, the argument goes, are relying more on domestically issued local currency debt, both inflation-indexed and non-indexed. This means their debts are far more stable and reliable than in the recent past, when a much larger share of government debt was issued externally and denominated in hard currency.

This argument is wrong. In the past, the combination of high levels of domestic debt and inflation surges has often proven deadly for both foreign and domestic investors. Just look at Argentina today...

Already, a good share of Argentina's debt is in default. What else do you call it when a government that owes over $30 billion in inflation-indexed debt ... is publishing an understated inflation rate that is used for calculating indexation payments. The official inflation rate in Argentina ... is under 10%. But the true inflation rate appears to be at least 30%... Fudging indexation clauses to effectively default on debt is an old game. ...

Over the course of history, emerging-market economies have had a hard time shaking off serial default. Each period of quiescence has been invariably followed by more turmoil, with the share of total countries in the world in default sometimes exceeding 40%, as it did during the mid-19th and 20th centuries.

Considering the duress of domestic bond holders across the world as global inflation rises, it is surprising that both private investors and multilateral international financial institutions seem so complacent about the rising risks of defaults on external debts.

The "this time is different" mentality is based on two mistakes. The first is the idea that domestic debt is something new. The other is the faulty economic logic that payments to domestic debt holders come out of a different pot than payments to external debt holders. ...

Earlier eras offer scant evidence that external creditors have been much safer than domestic debt holders. When India effectively defaulted on its domestic debt through massive inflation and financial repression in the early 1970s, external debt holdings suffered payment reschedulings even though they constituted only a tiny fraction of overall debt.

Emerging markets could be in much greater trouble than the optimistic consensus suggests. If today's tepid growth in the U.S., Japan and Europe begins to take hold in emerging markets, Argentina's miserable indexed bond holders may soon have company.

A New Role for the IMF?

Michael Bordo and Harold James say there are advantages to having the IMF act as a global reserve manager:

The IMF as a reserve manager, by Michael Bordo and Harold James, Vox EU: The IMF needs a new job. This column makes the case for the bold proposal that the IMF should manage a significant part of the new surplus countries’ sovereign wealth funds.

In the original conception of the 1944 Bretton Woods Conference, the International Monetary Fund (IMF) was created to deal with problems that had afflicted the interwar world, particularly the lopsided distribution of reserves and the deflationary consequences for the international economy – as well as with crisis management. Today the IMF has been almost completely sidelined from many of the major governance issues of the international financial system. In particular, it is much less active as a financial institution. The IMF’s diminished role seems at odds with the world’s need for global governance.

Today’s international financial system is characterised by numerous uncertainties. There are major debates about exchange rates; puzzlement about the large increases in reserves of many emerging market economies; worries about the strategic ambitions associated with the rapid rise to prominence of sovereign wealth funds; and concerns about the capacity of international financial institutions to respond to crises.

Some potential IMF reforms, such as those proposed ten years ago by Jose de Gregorio, Barry Eichengreen, Takatoshi Ito, and Charles Wyplosz1 , sought to make the IMF more relevant by making it less politically dependent. Such reforms, however, have usually been thought of as impractical.

There may be a case for a reform that harks back to the original Bretton Woods conception – although suitably updated for today’s world with its new lopsided distribution of reserves. The IMF could again become a powerful financial stabiliser if it took on a new role as the manager of a significant part of the reserve assets of the new surplus countries.

"Does Chinese Inflation now Constrain the Fed?"

Brad Setser:

Does Chinese inflation now constrain the Fed?, by Brad Setser: Tim Duy, with rather impressive timing, says yes. Rising inflation in China and the Gulf, the key regions in today’s “dollar zone,” now have a large enough impact on prices in the US to limit the Fed’s ability to cut rates further. Rather than setting monetary policy for the US, Duy — who had an office next to mine at the US Treasury back when we were both very junior new hires ten years ago — claims the Fed has to set policy for the entire dollar zone. ...

It is an intriguing argument ...[and] needs to be to be considered carefully, even if I am not yet sure I fully believe it. ... [...continue reading ...]

Brad DeLong: Gambler’s Ruin

Should developing countries keep betting on neo-liberal growth policies?:

Gambler’s Ruin, by J. Bradford DeLong, Project Syndicate: From Adam Smith (1776) until 1950 or so, capital was considered by economists to be absolutely essential for economic growth. You also needed a few good basic institutions. “Security of property and tolerable administration of justice,” as Smith put it. ...

For Smith and his successors over the first 175 years, any episode of sustained economic growth overwhelmingly required investment capital. We economists were by and large capital boosters, and our magic formula for economic development was saving, investment, thrift, and wealth accumulation. ...

Then Robert Solow and Moses Abramovitz challenged this near-consensus. They calculated that 75% to 80% of economic growth did not come from increasing the capital-output ratio... Instead, the keys to growth and development appeared to ...[be]: skills, education, technology broadly understood, and improvements in organizational management.

Yet capital continued to be seen as necessary, if not sufficient. In the framework developed by ... Dani Rodrik, a shortage of capital can be a binding “growth constraint”: the place where “the biggest bang for the [policy] reform buck can be obtained.” ...

The problem is that for poor economies, raising the capital needed to relax binding growth constraints is difficult. That’s why the world took the neo-liberal bet in the 1990’s: international capital mobility would come to the rescue by relaxing capital constraints where they were binding, and by reducing the scope for corruption and rent-seeking, which was often a more significant binding growth constraint.

The hope was that, like the pre-1913 era of British overseas investment, ... net capital outflows from the industrial core would finance much late twentieth and twenty-first century industrialization.

But we all know the outcome: ... the large net flow of capital from rich to poor countries simply never materialized. In fact, the principal outcome was an enormous flow of capital from the periphery to the rich core. ...

The reason is not that the periphery offers an attractive labor force from which capital profits, but rather that the core – especially the United States – offers a form of protection for capital against unanticipated political disturbances.

But even though net international capital flows are going the wrong way, there are still substantial gross capital flows outward from the world economy’s core to its periphery. And we can hope that these capital flows will carry with them the institutions and managerial expertise that have made the core so wealthy.

Nevertheless, a dispassionate observer might point out that for someone with limited resources and opportunities for policy reform to keep betting double-or-nothing on neo-liberalism is a strategy that has a well-deserved name: “Gambler’s Ruin.”

Rogoff: It's No Time for Oil Currency Hypocrisy from the US

Why is the U.S. sending inconsistent messages on exchange rate pegs?:

It's no time for oil currency hypocrisy from the US, by Kenneth Rogoff, Project Syndicate: Does it make sense for US Treasury Secretary Hank Paulson to be touring the Middle East supporting the region's hard dollar exchange-rate pegs, while the Bush administration simultaneously blasts Asian countries for not letting their currencies appreciate faster against the dollar? Unfortunately, this blatant inconsistency stems from the United States' continuing economic and financial vulnerability rather than reflecting any compelling economic logic. Instead of promoting dollar pegs, as Paulson is, the US should be supporting the International Monetary Fund's behind-the-scenes efforts to promote de-linking of oil currencies and the dollar.

Perhaps the Bush administration worries that if oil countries abandoned the dollar standard, today's dollar weakness would turn into a rout. But the US should be far more worried about promoting faster adjustment of its still-gaping trade deficit, which in many ways lies at the root of the recent sub-prime mortgage crisis. The administration's multi-pronged effort to postpone pain to US consumers, including super easy monetary and fiscal policy, only risks a greater crisis in the not-too-distant future. It is not at all hard to imagine the whole strategy boomeranging in early 2009, soon after the next US president takes office. ...

Foreign Exchange Markets and Fed Policy

Free Exchange says:

Tim Duy gets results.
 

Tim Duy: The Perils of Being the Reserve Currency

Tim Duy argues that "Fed Chairman Ben Bernanke can be criticized for following the wrong playbook" in his response to the financial crisis:

The Perils of Being the Reserve Currency, by Tim Duy: With inflation expectations in the US on the rise, the Fed is facing a withering round of Monday-morning quarterbacking. Have policymakers becomes hostage to Wall Street? And was the ransom demanded by Wall Street excessively stimulative? I tend to think policy is excessively stimulative, and the results incredibly predictable. Last October I wrote:

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy…

…In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

In my opinion, the surge in commodity prices since the Fed initiated its easing campaign should be no surprise. Too many of the world’s global central banks choose to follow Fed nearly lockstep, unleashing that wave of global liquidity I feared would come. Brad Setser reports:

Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative (”global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”) largely because of very high rates of inflation in the emerging world.

The recent acceleration in the rate of inflation in the emerging world reflects — I suspect — the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies.

From this perspective, Fed Chairman Ben Bernanke can be criticized for following the wrong playbook. Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.

This simply implies that the Fed does not sufficiently consider the reaction functions of other central banks when setting policy. Should they? In a world with limited capital flows, no. But in today’s globalized financial environment, the answer is increasingly yes. In effect, by encouraging open capital flows, the US has ceded some amount of domestic policy control.

Moreover, while being the producer of the reserve currency yields some benefits, notably the ability to run massive current account deficits at low cost, there are responsibilities as well. Namely, the responsibility to maintain the value of the currency. But the Fed has no such mandate. The Fed has a dual mandate of price stability and maximum employment. Protecting the external value of the Dollar is not the mission of the Fed until the Dollar falls so low as to be relevant to its legal mandate. Interestingly, only recently have other nations started to realize that the Fed’s objectives are thus nearly diametrically opposed from their own. From Brad Setser again:

"The US Dollar Hits an Oil Slick"

Martin Feldstein says to expect more rapid dollar depreciation in coming years:

The US dollar hits an oil slick, by Martin Feldstein, Project Syndicate [alt]: The rapid rise in the price of oil and the sharp depreciation of the dollar are two of the most noteworthy developments of the past year. ... To many observers, the combination of a falling dollar and a rise in oil prices appears to be more than a coincidence.

But what is the link between the two? Would the price of oil have increased less if oil were priced in euros instead of dollars? Did the dollars fall cause the price of oil to rise? And how did the rise in the price of oil affect the dollars movement? ...

Savings Glut or Investment Drought?

Brad Setser says case closed:

Case closed: A savings glut, not an investment drought, by Brad Setser: The data at the back of the IMF’s latest WEO (table A16) indicates that the emerging world’s savings surplus stems from a “glut” of savings, not a “drought” of investment.

In 2007, the savings rate of the emerging world savings was almost 10% of GDP higher than its 1986-2001 average. Investment was up as well – in 2007, it was about 4% higher than its 1986-2001 average. However the rise in the emerging world’s savings was so large that the emerging world could investment more “at home” and still have plenty left over to lend to the US and Europe. That meets my definition of a “glut.”

The big drivers of this trend. “Developing Asia” and the “Middle East.” ... It is historically unusually for an oil importing region to be saving so much when the oil exporters are also saving so much. Usually a rise in the savings of the oil exporters is offset by a fall in the savings of the oil importers. The enormous rise in Chinese savings even as China’s oil import bill has soared ... implies a bigger fall in the savings of other oil importing economies.

Government policy has played a big role in the high savings rates in both regions – whether the undistributed profits of Chinese state firms (a policy choice) or large fiscal surpluses of the Gulf financed by the undistributed profits of the Gulf’s state oil companies. It isn’t an accident that the emerging world’s savings glut has coincided with a rise of state capitalism... I suspect the emerging world’s savings glut largely reflects a glut in government (and SOE) savings.

Dr. Delong has argued that this savings surplus will persist for a long time, keeping US and European rates low and keeping housing prices in both the US and Europe higher than otherwise would be the case. Krugman’s fear that home prices need to fall significantly to bring the price-to-rent ratio closer to its long-term average won’t be born out.

Possibly. However, I don’t think it entirely implausible that savings rates in both Asia and the Middle East might start to converge toward their long-term average. What goes up sometimes also comes down. ...

Global Balances and Financial Underdevelopment

The question is, "why would emerging-market countries rely so heavily on foreign equity capital to finance the operations of local firms when they have access to a large pool of domestic savings that they are lending to the rest of the world?":

Are Global Imbalances Due to Financial Underdevelopment in Emerging Economies?, by Diego Valderrama, Economic Letter, FRB SF: Though much of the current discussion about global imbalances focuses on the swelling current account deficit in the U.S., the other side of this imbalance itself presents a puzzle. Specifically, the increase in U.S. international liabilities must be matched by an increase in assets elsewhere, and, in the current environment, a prominent "elsewhere" is among emerging Asian economies. For example, according to the World Economic Outlook (IMF 2007), in 2006 emerging Asian countries (including China, India, South Korea, and Singapore) accumulated $373.9 billion in reserves, a large portion of which is in the form of U.S. Treasury securities and other dollar-denominated assets. At the same time, these emerging-market countries also have relied to a large degree on private foreign direct investment (FDI) to finance domestic firms, receiving $40.5 billion in net private inflows (including FDI and portfolio equity investment) that year. So the puzzle is, why would emerging-market countries rely so heavily on foreign equity capital to finance the operations of local firms when they have access to a large pool of domestic savings that they are lending to the rest of the world?

Kenneth Rogoff: Has the Moment Come to Replace the US Dollar?

Kenneth Rogoff says it's a good thing the Euro isn't "fully ready for primetime":

Has the moment come to replace the US dollar?, by Kenneth Rogoff, Project Syndicate: As the world's financial leaders meet in Washington this month at the ... International Monetary Fund annual meeting, perhaps they should be glad there is no clear alternative to the dollar as the global currency standard. ... You can't treat your customers as badly as the United States has done lately if they can go elsewhere.

Over the past six years, the value of the trade-weighted dollar has fallen by more than a quarter, as the US has continued to rack up historically unprecedented trade deficits. With a soft economy, a badly compromised financial system, and serious concerns about rising inflation, the long-term dollar trend is downward... And it is not over.

The Federal Reserve's bailout of the financial system is unlikely to stand up unless banks find fresh capital, and lots of it. Ultra-rich sovereign wealth funds have the cash to rescue US banks. But they are unlikely to want to do so... The problem is that after so many years of miserable returns on dollar assets, will global investors really be willing to absorb another $1 trillion in US debt at anything near current interest rates and exchange rates?

US debt hardly looks like a bargain right now, even without the sinking dollar. Far-flung military misadventures continue to stretch the country's fiscal resources, with costs potentially running into many trillions of dollars...

Next year will almost certainly see a massive rise in US corporate defaults... State and municipal finances are in even worse shape. With tax revenues collapsing due to falling home prices and incomes, dozens of US municipalities could well go into receivership, as New York City did in the 1970s. US municipal bonds are already trading at huge risk premiums, and the first big government default hasn't even hit yet.

Of course, if the dollar were to fall off its perch as the world's dominant currency any time soon, the euro would be the only serious alternative. ...

Fortunately for the dollar, the euro, too, seems to have its problems. ...

But the euro does have growing strengths. ...[T]he European Central Bank has gained considerable credibility from its handling of the global credit crisis. Indeed, if the euro zone can persuade Great Britain to become a full-fledged member, thereby acquiring one of the world's two premier financial centers (London), the euro might start to look like a viable alternative to the dollar. ...

World currency standards have enormous inertia. The British pound only forfeited its role to the US dollar after more than 50 years of industrial decline and two world wars. But it could happen a lot faster this time. As central bankers and finance ministers ponder how to intervene to prop up the dollar, they should also start thinking about what to do when the time comes to pull the plug.

Feldstein on the Falling Dollar

Martin Feldstein says we're fortunate, the decline in the dollar is coming at a good time:

The dollar is falling at the right time, by Martin Feldstein, Commentary, Financial Times: The dollar’s recent decline ... triggered numerous calls for exchange rate intervention. ... But intervention proposals misunderstand the significance of ... the recent dollar declines, ... and the potential adverse effects of intervention. ...

The value of the dollar, like other asset prices, fluctuates substantially from year to year. But over long periods of time the dollar’s real value has changed very little. The real, inflation-adjusted value of the dollar against a broad basket of currencies, has declined only 7 per cent over the past 20 years...

The recent decline of the dollar has led many people to talk about the current “weakness” of the dollar, encouraging intervention to stop the dollar’s further decline. This confuses recent declines with fundamental weakness. The very large US trade deficit shows that the value of the dollar is ... actually very strong. Because of the dollar’s strength, prices of US goods in global markets make them inadequately competitive.

The dollar’s decline over the past five years stimulated exports and helped to shrink the trade deficit. ... But the trade deficit last year was still more than $700bn or 5.1 per cent of gross domestic product. Since US imports are still nearly twice as large as US exports, it takes a very large fall of the dollar to shrink the net deficit.

Despite the recent dollar decline, America’s trading partners still have large trade surpluses. ... So the more competitive dollar is not causing fundamental trade problems for America’s trading partners.

The falling dollar reflects an unwillingness of private and public portfolio investors around the world to hold the current amounts of dollar securities at the existing interest rate and exchange rate. To induce them to do so, and to increase their holdings by the roughly $700bn needed to fund this year’s US current account deficit, requires either a lower value of the dollar ... or a higher rate of interest... A lower dollar has the favourable effect of stimulating US net exports and therefore of raising the US growth rate at a time of general economic weakness. In contrast, higher interest rates would reduce aggregate investment and other aspects of aggregate demand. The US has therefore been fortunate that the adjustment to the fall in world demand for US securities has taken the form of a lower dollar rather than of a rise in the level of US interest rates.

Exchange rate intervention to strengthen the dollar would be ... counterproductive. If it succeeded, it would cause the dollar to rise when the US economy needs a more competitive dollar. ... Investors and policy officials should recognise that the dollar’s current decline is part of a natural process for reducing the US trade deficit. Because of the potential weakness of the US economy in the coming months, the dollar decline and the resulting reduction in the trade deficit have actually come at a good time.

Martin Feldstein: The European $afety Net

Martin Feldstein on the impact of the falling dollar:

The European $afety Net, by Martin Feldstein, Project Syndicate: When the euro's value reached an all-time high of $1.52, the president of the European Central Bank, Jean-Claude Trichet, told the press that he was concerned ... and wanted to "underline" the United States Treasury's official policy of supporting a strong dollar. Several European finance ministers subsequently echoed a similar theme.

In reality, of course, America does not have a dollar policy — other than letting the market determine its value. The American government does not intervene in the foreign exchange market to support the dollar...

Nevertheless, all U.S. Treasury secretaries, going back at least to Robert Rubin in the Clinton administration, have repeated the mantra that "a strong dollar is good for America"... Indeed, the Treasury's only explicit currency goal now is to press the Chinese to raise the value of the renminbi... The pressure on China is, however, entirely consistent with the broader American policy of encouraging countries to allow the financial market to determine their currencies' exchange rate....

[W]hile the declining dollar does reduce Americans' purchasing power, the magnitude of this effect is not large, because imports account for only about 15% of U.S. gross domestic product. A 20% dollar depreciation would therefore reduce Americans' purchasing power by only 3%. At the same time, the lower dollar makes American products more competitive in global markets, leading to increased exports and reduced imports. ...

On a real trade-weighted basis, the dollar is down about 13% relative to its value in March 2006. This improved competitiveness of American goods and services is needed to shrink the massive American trade deficit. ... [T]he dollar must fall substantially further to shrink the trade deficit to a sustainable level. ...

Instead of simply wishing that the dollar would stop falling, European governments need to take steps to stimulate domestic demand to replace the loss of sales and jobs that will otherwise accompany the more competitive dollar. This is not an easy task, because the European Central Bank must remain vigilant about rising inflation, and because many E.U. countries maintain large fiscal deficits.

While the ECB has limited room for maneuver, regulatory changes, and revenue-neutral shifts in the tax structure (for example, a temporary investment tax credit financed by a temporary increase in the corporate tax rate) could provide the stimulus needed to offset declining net exports. It is therefore important that E.U. governments turn their attention to this challenge.

Marty Feldstein was in the news yesterday:

Marty is scared, by Greg Mankiw: Reuters reports:

The United States is in a recession that could be "substantially more   severe" than recent ones, National Bureau of Economic Research President   Martin Feldstein said on Friday. "The situation is very bad, the situation is   getting worse, and the risks are that it could get very bad."... Feldstein said the downturn could be the worst in the United States since   World War Two.

Feldstein was in competition with Ben Bernanke to head the Fed after Greenspan. Think he's glad he escaped this turmoil, or if he wishes he could lead the Fed in this crisis? Probably some of both.

Sovereign Wealth Rules?

I'm haven't been too concerned about sovereign wealth funds, except to the extent that they present political difficulties that might trigger a harmful protectionist backlash, but Larry Summers says there are reasons to ask questions about their "multiple motives." However, he says, it's nothing a set of voluntary guidelines can't fix:

Different money, different rules, by Lawrence H. Summers, Commentary, International Herald Tribune: Along with the prominent emergence of sovereign wealth funds on the global scene, some key questions arise.

The first revolves around the issue of "multiple motives." What is the primus of capitalism? It is that people invest ... in order to maximize their value. If you think about national ownership of a ... business..., or even a direct investment made by a public pension fund in the United States, the same issue arises: There can be motives other than highest rate of return.

For example, perhaps a state-owned fund wants an airline to fly to its country. Perhaps it wants a bank to do extensive business in its country. Perhaps it wants suppliers from its country to be sourced. Perhaps it wants to disable an industry that competes with its nation's national champion. These other motives distort the whole notion of capitalism that value maximization is the chief objective.

Another concern is general politicization. Suppose a country ran an active trading operation and found itself in an investment much like George Soros's short position in the British pound in 1992. Would we be comfortable with the concept that nation X found that the fixed exchange rate of nation Y was untenable and wanted to launch a speculative attack against it? That is not conducive to successful relations between nations. There should be some kind of understanding that this is not going to happen.

Suppose the sovereign wealth fund in one country makes an investment in a major bank in another country. Then the bank gets in big trouble. There is no question as to whether investors are going to be bailed out. But is there any country in the world that can assert confidently that, with billions of dollars on the line, their head of state and foreign minister are not going to become involved in the negotiation of that transaction? Do we think that kind of thing is healthy for modern markets?

The question is not whether we should have sovereign wealth funds. They are terrific. Should we be against them simply because they are foreign? No. That's terrible. The question is: If we believe in market economies, and we work very hard to create open markets..., shouldn't we establish some set of standards that address the kinds of concerns ... that arise because of ... cross-border nationalization?

One suggestion is that the sovereign wealth funds themselves should get together and put an end to all this worry and discussion by agreeing to a number of principles to which they will abide - for example that under no circumstances are they going to speculate in currencies, they are always going to be long term investors and they are never going to use sovereign wealth funds to pursue any national political objective.

If sovereign wealth funds were to say they agree to these rules, that they have never done otherwise and never intend to, it would allay all the fears out there. It is the unwillingness to agree to such standards openly that is not wholly reassuring.

"Expansionary Aggregate Demand Policies are Likely to Bring about a Period of Stagflation"

Guillermo Calvo responds to Larry Summers call to to move beyond monetary and fiscal stimulus and begin repairing the underlying problems in the financial system. While he agrees that the financial system needs to be strengthened, he does not have much faith in monetary and fiscal policy and believes their use will result in stagflation:

Guillermo Calvo, Economic Forum: I agree that we need “consistent, determined approaches” which will probably take us far beyond conventional monetary and fiscal policy. The main problem, however, is that we don’t seem to have a consistent macro view that is widely agreed upon and is itself consistent with the stylized facts of the current crisis. Thus, for example, policy has strongly relied on lowering the reference interest rate, a policy that is typically justified in models that abstract from credit market difficulties. The same applies to fiscal expansion. This lack of intellectual consistency is bound to create further confusion. Thus, I would encourage Larry and the other high-profile commentators to give a simple but clear view of their underlying assumptions.

To be consistent with my preaching, let me say that I am of the view that the current subprime crisis is starting to look more and more like those in emerging markets. The big but somewhat superficial difference, however, is that initially the problem did not entail a whole country but a sector (and, incidentally, since a sector does not print its own money, its situation is similar to that in emerging markets which suffer from Liability Dollarization, or Original Sin). Since the subprime sector hit the global financial market, it had the potential to damage other sectors through contagion, much like it happened in emerging markets after the Russian August 1998 crisis. Thus, we are witnessing the effects of a “supply” shock, implying that the crisis is unlikely to be fully resolved by a stimulus to aggregate demand through lower interest rates. And even less by transitory fiscal expansion, for the additional reason that credit crises involve “stocks,” while transitory fiscal policy involves “flows.” Thus, if you agree with my view, a key to resolving the current crisis is to reinforce the financial sector which, incidentally, leads me to enthusiastically agree with Larry's thrust in his column. But, on the other hand, I have a much less favorable opinion about expansionary monetary and fiscal policy. These aggregate demand policies are easy to implement in the short run, while strengthening the financial sector is time consuming. Since the latter would be key for avoiding a slowdown, expansionary aggregate demand policies are likely to bring about a period of stagflation, seriously undermining the credibility of policymakers.

The Challenge of Sovereign Wealth Funds

There are lots of worries about sovereign wealth funds and what countries who have amassed large amounts of financial assets might do with the money. For example, if a foreign country decides to invest in and take majority control of the Wall Street Journal, CBS, or key strategic industries in the economy, are we completely comfortable with that? Is there a line that shouldn't be crossed? In the Vox EU article below, Philipp Hildebrand develops a voluntary code of conduct for investments by sovereign wealth funds with an eye toward avoiding protectionist responses to acquisitions by countries controlling the funds.

Here's another potential solution. In financial markets, savings are made available in two ways, through direct and indirect finance. When the relationship is direct, the borrower and lender are known, e.g. if I buy a stock in a company, I know which company received my money and the company knows who bought the stock, it knows who lent them the money. In essence, though brokers, etc. may be involved, these transactions are "face to face". Think of a loan from friend as an example - and also all the problems, hard feelings and so on that come with a loan from a a friend as compared to, say, a small loan of the same amount from a bank.

With indirect finance, it's different. In this case, the borrower does not know for sure who borrowed their money, and the lender does not know for sure who provided the funds. A traditional bank plays this role. A large number of depositors put their money into a bank, the deposits are pooled together into one big "loanable fund", and somewhere else in the bank the money is lent to borrowers that appear to be acceptable credit risks. When I deposit a dollar in a bank, I don't know for sure which of the many borrowers receives that dollar - nobody bothers to keep track - and the borrower does not know who provided the money behind the loan.

[Source: Mishkin's Money and Banking Text]

I think a lot of the problems we are worried about with sovereign wealth funds could be avoided by setting up an indirect international financial intermediary. If all of these countries were to get together, pool their funds into an international bank, and then hire a professional staff to evaluate and make loans, buy stocks, and make other investments all over the world, many of the problems of direct finance could be avoided. Because the funds are pooled, the exact identity of the country providing the funds would be unknown to the borrower thus reducing substantially worries about using these funds for strategic or political advantage. Furthermore, since market processes are at work as agents decide to take out a loan (or not), the return on these investments would likely be higher than what individual countries might earn trying to target and make these investments themselves (and when mistakes are made, losses are pooled across countries rather than falling wholly on individual countries).

Politics won't be avoided entirely with such an intermediary - for example some countries could be denied access for political or other reasons - but it seems to me that some institution that serves to pool funds before they are lent solves a lot of the problems that come with more direct lending arrangements. And with such an institution in place and ready to make loans to all who qualify, I would be much less worried about rules limiting the degree to which sovereign wealth funds can exert direct control over assets within a foreign country.

Here's Philipp Hildebrand:

The challenge of sovereign wealth funds, by Philipp M. Hildebrand, Vox EU: Sovereign wealth funds (SWFs) are not a new phenomenon. With its Caisse des Dépots et Consignations, France essentially set up a SWF in 1816![1] But such funds have recently grown both in number and size and now exceed the combined assets of hedge funds and private equity. Their rapid growth is closely linked to the prevailing global macroeconomic imbalances, and that means that SWFs will be around for some time to come. Even under the assumption that global imbalances unwind over the next ten years and commodity and oil prices revert to long-term averages, these funds will continue to deploy substantial financial assets in the global market place.

The rise in SWFs has undoubtedly brought a number of benefits. One of these has become particularly evident recently. Against the backdrop of the current market turmoil, SWFs have been a welcome source of capital, strengthening the vulnerable balance sheets of some of the world’s largest financial institutions. But they have also given rise to considerable political controversy, as their rapid ascent challenges some long-held assumptions about how the global economy works.

Paul Krugman: Don’t Cry for Me, America

How did we end up with problems usually associated with third-world economies?:

Don’t Cry for Me, America, by Paul Krugman, Commentary, NY Times: Mexico. Brazil. Argentina. Mexico, again. Thailand. Indonesia. Argentina, again. And now, the United States.

The story has played itself out time and time again... Global investors, disappointed with the returns they’re getting, search for alternatives. They think they’ve found what they’re looking for in some country or other, and money rushes in.

But eventually it becomes clear that the investment opportunity wasn’t all it seemed to be, and the money rushes out again, with nasty consequences... That’s the story of multiple financial crises in Latin America and Asia. And it’s also the story of the U.S. combined housing and credit bubble. These days, we’re playing the role usually assigned to third-world economies. ...

The global origins of our current mess were ... laid out by ... Ben Bernanke ... in 2005... Mr. Bernanke asked a good question: “Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets — rather than lending, as would seem more natural?”

His answer was that ... third world economies ... were shaken by a series of financial crises beginning in 1997. As a result,... their governments began accumulating huge precautionary hoards of overseas assets.

The result, said Mr. Bernanke, was a “global saving glut”... In the end, most of that money went to the United States. Why? Because, said Mr. Bernanke, of the “depth and sophistication of the country’s financial markets.”

All of this was right, except for one thing: U.S. financial markets ... were ... not, in fact, uniquely well-suited to make use of the world’s surplus funds. It was, instead, a place where large sums could be and were invested very badly. Directly or indirectly, capital flowing into America ... ended up financing a housing-and-credit bubble that has now burst, with painful consequences. ...

[T]hese consequences probably won’t be as bad as the devastating recessions that racked third-world victims.... The saving grace ... is that our foreign debts are in our own currency. This means that we won’t have the kind of financial death spiral Argentina experienced, in which a falling peso caused the country’s debts, which were in dollars, to balloon in value...

But even without those currency effects, the next year or two could be quite unpleasant.

What should have been done differently? Some critics say that the Fed helped inflate the housing bubble with low interest rates. But those rates were low for a good reason: although the last recession officially ended in November 2001, it was another two years before the U.S. economy began delivering convincing job growth, and the Fed was rightly concerned about the possibility of Japanese-style prolonged economic stagnation.

The real sin, both of the Fed and of the Bush administration, was the failure to exercise adult supervision over markets running wild.

It wasn’t just Alan Greenspan’s unwillingness to admit that there was anything more than a bit of “froth” in housing markets, or his refusal to do anything about subprime abuses. The fact is that as America’s financial system has grown ever more complex, it has also outgrown the framework of banking regulations that used to protect us — yet instead of an attempt to update that framework, all we got were paeans to the wonders of free markets.

Right now, Mr. Bernanke is in crisis-management mode, trying to deal with the mess his predecessor left behind. ... I suspect that it’s already too late to prevent a recession.

But let’s hope that when the dust settles a bit, Mr. Bernanke takes the lead in talking about what needs to be done to fix a financial system gone very, very wrong.

"Can we Predict Exchange Rates? Economic Evidence against the Random Walk Model"

According to this research, the forward premium, the difference between the forward exchange rate and the spot exchange rate, can help to predict short-run exchange rates and "investors who ignore it and use random walk models may be leaving money on the table":

Can we predict exchange rates? Economic evidence against the random walk model, by Pasquale Della Corte, Lucio Sarno, and Ilias Tsiakas, Vox EU: Exchange rates are important to innumerable economic activities. Tourists care about the value of their home currency abroad. Investors care about the effect of exchange rate fluctuations on their international portfolios. Central banks care about the value of their international reserves and open positions in foreign currency as well as about the impact of exchange rate fluctuations on their inflation objectives. Governments care about the prices of exports and imports and the domestic currency value of debt payments. Markets care both directly - the market for foreign exchange is by far the largest market in the world – and indirectly, since exchange-rate shifts can affect all sorts of other asset prices.

No surprise then that forecasting exchange rates has long been at the top of the research agenda in international finance. Still, most of this literature is characterised by empirical failure. Starting with the seminal contribution of Meese and Rogoff (1983), a vast body of empirical research finds that models which are based on economic fundamentals cannot outperform a naive random walk model (i.e. the exchange rate is, at any moment of time, as likely to rise as it is to fall). Therefore, the prevailing view in the international finance profession – shared in academic and policy circles as well as in a large fraction of the practitioner community – is that exchange rates are not predictable, especially at short horizons. In academic jargon, exchange rates are thought to follow a random walk.

Selling American Banks to Sovereign Wealth Funds

Joe Stiglitz and Jamie Galbraith on selling off American banks to sovereign wealth funds: Link to audio file.

From Tigers to Kittens?

Recently, the World Bank announced new estimates implying that the economies of China and India are smaller than we thought. How do we compare incomes across countries? Should the new estimates for China and India should change our view of those countries and their role in the world economy? Here's Eswar Prasad:

Tigers or Kittens?, by Eswar Prasad, Commentary, International Herald Tribune: The World Bank stunned the world recently when it announced that the economies of China and India are about 40 percent smaller than previous estimates.

How is it possible to shrink such large economies so much overnight, turning them from tigers into kittens? And what does it mean...? The answer depends on whether you care more about reality or hype.

This debate's origin lies in an arcane-sounding concept called purchasing power parity. Here's the logic: In comparing incomes earned by people in different places, what really matters is the standard of living those incomes can deliver. This depends on local price levels. An annual income of $100,000 is enough for a comfortable life in Des Moines but barely enough to get by in New York City.

The same logic applies to countries. One way to compare the incomes of various countries is to use the currency exchange rate to express their incomes in a common unit such as the dollar. But exchange rates are buffeted by various factors and may not capture true purchasing power. Ideally, we'd like to measure the cost of an identical bundle of goods in different countries ... and then adjust national incomes...

Clearly, this is a complex calculation. One needs to find comparable products in different countries, account for subtle differences in the quality of products, make adjustments for price variations within a country, and so on. ...

The World Bank has made a noble effort at constructing comparable international prices. ... Nevertheless, conspiracy theories abound. The new estimates imply that there are many more poor people in China and India, so the World Bank may be extending its own lease on life (one of its aims is to end poverty). But both countries now have less of a claim to a bigger stake in the World Bank and the International Monetary Fund, where economic might determines voting power.

There are also implications for the debate about whether China is manipulating its exchange rate to keep its currency undervalued and its exports cheaper... The new data imply that the degree of such undervaluation is far lower than some analysts had suggested, which ought to mute China-bashing.

The assertion that such large data revisions must be driven by a political agenda is a tall claim. Even the United States revises its output and price data substantially every few years. ...

Collecting national accounts data is an imprecise science ... and there are still huge gaps in these data, even in advanced industrial countries. Improvements in these data are to be welcomed. But the revisions should be treated with circumspection and not immediately result in a massive shift in world-view.

Even if one takes the new data seriously, the bottom line is that they do not change ... reality... These two countries are still growing rapidly, consuming as many resources, and spewing out as much pollution as before.

It is still the case that in 2007 China will run a huge trade surplus, ... at least $250 billion... Together, China and India still hold nearly $2 trillion of foreign exchange reserves.

What's changed is the perception that China will soon take over the world if it keeps growing at 10 percent a year. Or that China and India are the new engines for world growth, with the U.S. business cycle mattering a lot less. The people who bought into those overblown ideas are the ones most shaken by the new numbers.

The new World Bank data may change our perception of reality. But much of the reality is no different from what it was. The rest is just hype.

"The Subprime - Trade Deficit Connection"

Thomas Palley emailed this to me earlier today, but with classes starting tomorrow I haven't had time to read it carefully enough to say anything useful, so I will simply pass it along:

The Subprime - Trade Deficit Connection, by Thomas I. Palley: In recent months the U.S. subprime mortgage crisis has been rippling outward affecting other countries. British banks have made large loan loss provisions and there has been a run on the Northern Rock bank. German banks have incurred similar losses and Germany has suffered two large bank failures. European banks have also become leery about lending to each other, forcing the European Central bank to infuse emergency liquidity. Now, Japan’s banks are feeling the heat.

These global spillovers have their origin in the huge U.S. trade deficits of the last several years. Those deficits played a critical role generating the distorted interest rate environment that created the sub-prime bubble, and they also explain how subprime loans have wound up in Tokyo portfolios. For policymakers everywhere there are lessons about the dangers of large trade deficits.

Over the last several years, the U.S. trade deficit has persistently drained spending from the U.S. economy. As a result, much of manufacturing failed to recover after the recession of 2001, making for a weaker than usual recovery. This weakness prompted the Federal Reserve to push interest rates to historic lows in 2003, keep them there for an extended period, and then only raise rates gradually for fear of undermining the economy.

The Fed’s “easy money” policy succeeded in avoiding a relapse into recession, but it came at the price of a housing bubble and a twisted expansion. The hallmarks of this twisted expansion were house price inflation, a construction boom, explosive growth of non-traditional subprime mortgages, a debt-financed consumer spending binge, and yet larger trade deficits.

Reading the Dollar Signs

Here's a follow-up to Thomas Palley's argument that the dollar is in no immediate danger of losing its status in the world. This takes a somewhat different position:

Dollar signs, by Howard M. Wachtel, Commentary, LA Times: Has the tipping point arrived when the U.S. dollar ceases to be the preeminent reserve currency in the global economy -- a status it has held for 60 years? Such conjecture has been triggered by the recent dip in the dollar against the euro...

Since World War II, the dollar has been held as reserves by other countries in their financial portfolios because of its universal acceptance in the world economy and its stable value.

For the country whose currency achieves this status, there are considerable advantages. The United States can run large trade deficits, buying more than it sells in the world, because the selling countries are eager to acquire dollars as reserves. Such trade deficits are in reality debts whose reconciliation can be postponed as long as countries seek dollars as reserves. Political power also derives from this financial reality, as countries become willing to accommodate the reserve currency country in order to gain access to that currency.

"Don’t Bet Against the Dollar"

Thomas Palley emails his latest with the message "I thought this piece might generate some argument":

Don’t Bet Against the Dollar, by Thomas Palley: The global economy runs on the dollar, and that isn’t about to change. Today the world’s central banks hold about two thirds of their reserves in U.S. dollars. Most commodities are priced in American currency, and much of world’s trade is invoiced in dollars as well. The dollar is the lifeblood of the international system.

Still, a growing number of observers, pointing to persistent U.S. trade deficits and the dollar’s depreciation against the euro, have begun to speculate that the dollar’s day is coming to an end. If they were right, this would be a worrisome development. First, an exit from the dollar would lead to its further depreciation, causing increased import prices that might trigger higher inflation. Second, a decline in demand for dollar assets would cause a fall in asset prices and raise interest rates, which could cause a recession and permanently slow U.S. economic growth.

Fortunately, these fears are misplaced.

Rogoff: Dog Days for the Super Dollar

Kenneth Rogoff on a popular topic recently, the dollar, where it's headed, and whether we are going with it. His conclusion is that unless "the US gets its act together soon," there could be trouble ahead:

Dog days for the super dollar, by Kenneth Rogoff, Project Syndicate: Is the United States' position as the world's dominant superpower at risk if the dollar loses its super-currency status? Maybe not, but Americans will certainly find global hegemony a lot more expensive if the dollar falls off its perch.

Brad DeLong: Is the Dollar Leading Us into a Depression?

Brad DeLong's outlook for the economy in light of the falling dollar is not as optimistic as Tyler Cowen's, but he does see reason for hope. Unfortunately, that hope is based upon the typical investor misperceiving the risk of a dollar decline which makes me wonder what will happen if (when?) these investors, en masse, suddenly realize their mistake. Beep beep?:

Is the dollar leading us into a depression?, by J. Bradford DeLong, Project Syndicate: The falling US dollar has emerged as a source of profound global macro-economic distress. ... Is the world economy at risk? There are two possibilities. If global savers and investors expect the US dollar's depreciation to continue, they will flee the currency unless they are compensated appropriately for keeping their money in the US and its assets, implying that the gap between US and foreign interest rates will widen. As a result, the cost of capital in the US will soar, discouraging investment and reducing consumption spending as high interest rates depress the value of households' principal assets: their houses.

The resulting recession might fuel further pessimism and cutbacks in spending, deepening the downturn. A US in recession would no longer serve as the importer of last resort, which might send the rest of the world into recession as well. A world in which everybody expects a falling US dollar is a world in economic crisis.

By contrast, a world in which the US dollar has already fallen is one that may see economic turmoil, b