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Wednesday, February 07, 2007

Kenneth Rogoff: Why Hasn't the Dollar Crashed Yet?

Ken Rogoff looks at "the world's largest foreign aid program," foreign loans to the U.S., why the dollar hasn't collapsed under increasing pressure from the trade deficit, and the risks ahead:

Betting with the house's money, by Kenneth Rogoff, Project Syndicate: Many people have been asking why the dollar hasn't crashed yet. Will the United States ever face a bill for the string of massive trade deficits...? ...[S]taggeringly, US borrowing now soaks up more than two-thirds of the combined excess savings of all the surplus countries in the world...

Foreigners are hardly reaping great returns on investing in the US. On the contrary, they typically get significantly lower returns than Americans get on their investments abroad. ...[T]he central banks of Japan and China are holding almost two trillion dollars worth of low-interest bonds. A very large share of these are US treasury bonds and mortgages. This enormous subsidy to American taxpayers is, in many ways, the world's largest foreign aid program. ...

Most sober analysts have long been projecting a steady trend decline in the dollar... So why hasn't more adjustment taken place already? The first answer, of course, is that the trade-weighted dollar has fallen - by more than 15% in real terms since its peak in early 2002. Yet the US deficits have persisted, and even risen, since then.

The real driving force has been two-fold. First and foremost, America's government and consumers have been engaged in a never-ending consumption binge. On the consumer side, this is quite understandable. ...

Overall, after almost 25 years of stunning prosperity, punctuated by only two mild recessions, most Americans feel pretty confident about their economic situation. ... So it is not surprising that private consumption continues to hold up... People have enjoyed such huge capital gains over the past decade that most feel like gamblers on a long winning streak. By now, they see themselves as playing with the house's (or their houses') money.

It is less easy to rationalise why the US government is continuing to run budget deficits despite a cyclical boom. When a fiscally responsible government launches a war, it typically cuts back on other domestic expenditures and raises taxes. The Bush administration did the opposite. It may not be good economics, but the strategy proved to be good politics, for a time. Unfortunately, it is unlikely the new Democratic majority in Congress will do much about it.

Of course, it takes two to tango. In order for the US economy to run deficits with the world, other countries must be willing to ... supply ... savings. Ben Bernanke ... once famously pinned the whole US current account deficit on a "global savings glut". But it would be more accurate to say that there is global investment shortfall, with investment trending downwards despite the upward trend in global growth.

This investment shortfall is due to many factors, but perhaps the main one is ... substantial medium-term institutional roadblocks to investment in many developing countries, where long-term returns now seem to be by far the highest. The net result is that money is being parked temporarily in low-yield investments in the US, although this cannot be the long-run trend.

What then is future of the dollar? As long as the status quo persists, with strong global growth and stunning macroeconomic stability, the US can continue to borrow and run trade deficits without immediate consequence. Over time, the dollar will still decline, but perhaps by no more than a couple of percent a year. Nevertheless, it is not hard to imagine scenarios in which the dollar collapses. Nuclear terrorism, a slowdown in China, or a sharp escalation of violence in the Middle East could all blow the lid off the current economic dynamic. ...

In sum, the fact that the US trade balance has defied gravity for so many years has made it possible for the dollar to do so, too. But some day, the US may well have to pay the bill for its spendthrift ways. When that day arrives, Americans had better pray that their creditors will be as happy to accept dollars as they are now.

Update: Kenneth Rogoff continues to worry about the stability of the global financial system. This is from the Financial Times:

No grand plans, but the financial system needs fixing, by Kenneth Rogoff, Commentary, Financial Times: What ever happened to all the grandiose plans for improving the global financial architecture? Up until a few years back, leading policy economists seemed to be tripping over themselves to come up with blueprints for radical change. Particularly popular were plans for new global institutions... More modest plans (such as mine) merely called for a sweeping restructuring of the major existing multilateral financial institutions, the International Monetary Fund and the World Bank.

Over the past couple of years, however, all introspection appears to have vanished. Instead, the policy community has developed a smug belief that enhanced macroeconomic stability at the national level combined with continuing financial innovation at the international level have obviated any need to tinker with the system. ... There is no problem that markets cannot solve.

Really? How well would markets handle the fallout from a sharp slowdown in India or China? How would they react to a dirty nuclear bomb in a US city..., and a sudden reluctance on the part of global investors to keep financing America’s 800-plus billion dollar current account deficit? Or a rapid escalation of conflict in the Middle East that encompassed Iran and Saudi Arabia? ...[C]ontrary to market perceptions, global central banks have only very limited instruments for dealing with a genuinely sharp rise in global volatility, particularly one that is geo-politically induced.

True, it is not clear that any of the grand plans of the past couple of decades would better equip the world economy to deal with such catastrophic shifts. The typical grand plan was far too simplistic and heavy-handed... But just because most grand plans were far too simplistic does not mean we should dismiss the deeper problems that they aimed to address. ...

The real shame with the disappearance of grand plans is that they had provided a valuable reservoir of ideas to spur major improvements in the world’s existing multilateral financial institutions. ...

We should bemoan the world’s lack of interest in grand plans to improve the financial architecture, but not because any of them was necessarily perfect. The problem, rather, is a lack of the purpose and energy needed to sustain even more modest, and unambiguously positive, reforms. Which means, of course, that after the next round of crises, we shall be deluged with even more and even grander plans.

    Posted by on Wednesday, February 7, 2007 at 12:28 PM in Economics, International Finance, International Trade | Permalink  TrackBack (1)  Comments (48)

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