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Friday, November 09, 2007

"Flashback to 1985: Krugman’s View On the Dollar"

When we last heard from Richard Baldwin, I introduced his Vox EU paper with:

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":

Richard concluded with:

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.

He has just added a postscript:

Flashback to 1985: Krugman’s view on the dollar, by Richard Baldwin:  Rummaging around the web last night I came across a Paul Krugman paper on the how far and how fast the dollar needed to fall. What’s noteworthy is the date. Paul wrote it in August 1985 for the Jackson Hole conference when the US trade deficit seemed huge and the dollar had just started its 3-year slide. The 1985 abstract could be the abstract for his February 2007 article on the same subject.

This paper presents evidence strongly suggesting that the current strength of the dollar reflects myopic behavior by international investors; that is, that part of the dollar's strength can be viewed as a speculative bubble. At some point this bubble will burst, leading to a sharp fall in the dollar's value. The essential argument is that given the modest real interest differentials between the U.S. and its trading partners, the dollar’s strength amounts to an implicit forecast on the part of the market that with high probability the dollar will remain very strong for an extended period. The paper shows that such sustained dollar strength would lead the U.S. to Latin American levels of debt relative to GNP, which is presumably not feasible. Allowing for the possibility that something will be done to bring the dollar down before this happens actually reinforces the argument that the current value of the dollar is unreasonable.

Of course, Paul has become a much better writer since then, so the “bubble will burst, leading to a sharp fall in the dollar's value” is now the “Wiley E. Coyote moment,” but the economic logic has not changed. Paul’s thesis adviser was Mr. Overshooting, Rudi Dornbusch. You could not complete Rudi’s course at MIT, 14.582, without having the link between current interest rates and market expectations of depreciation tattooed inside your brain. Paul’s prediction in 1985 and this year simply add a rough calculation as to whether the US trade deficit would become unsustainably large if the dollar fell as slowly as the interest rate gap would suggest. Here are a couple of quick charts that provide historical perspective. Both are flawed since they are in nominal terms, but they illustrate the point.

Baldwin1

Baldwin2
Click on graphs for larger versions

    Posted by on Friday, November 9, 2007 at 02:52 AM in Economics, International Finance | Permalink  TrackBack (0)  Comments (22)

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