links for 2007-11-20
links for 2007-11-21

Willem Buiter Cries "Doom! Doom!" for the Dollar

Willem Buiter:

Our currency and our problem: In 1971, the then US Secretary  of the Treasury, John Connolly told his European counterparts: "the dollar is our currency but your problem." So far, Connolly's statement continues to be true.  Every time the dollar weakens, US exporters and US import-competing industries are gaining competitive advantage and/or increasing their profitability.  The explosive growth of US export volumes... is part of the reason that, despite the collapse of US housing construction, the US economy is still expanding.... The weaker dollar also improves the US net external investment position.... With so much of US external liabilities denominated in dollars, every time the dollar weakens, the world largest debtor feels a little wealthier. The Chinese authorities, despite moves to diversify their foreign asset holdings, still... hold over a trillion dollars... in US Treasury... The Japanese authorities have a similar exposure... have re-confirmed their reputations for being among the world's worst portfolio investors.... [T]he Chinese and Japanese authorities... presenting their tax payers with a further $200bn to $300bn capital loss... a heavy price to pay for access to US markets for your exports, especially for a poor country like China....

I fear, however, that the good news about dollar weakness for the US is about to come to an end. Sooner rather than later, the weakness of the dollar, and fear of its future weakening, will trigger a large increase in long-term US interest rates, nominal and real.... The further weakening of the US dollar will continue to boost the tradable sectors of the US economy, but any sharp increase in long-term nominal and real interest rates will hit investment spending.... It won't be pretty.  Expansionary monetary policy measures will be limited because a collapse of the dollar will have non-trivial inflationary consequences...

It is not clear to me what model Buiter is working in. In economists' default model, expectations are, in general, not of a particular rate of change of the dollar but of a future level for the dollar. If domestic interest rates are high (relative to interest rates abroad, adjusted for risk and other factors) then the value of a currency will be above its long-run expectation. If If domestic interest rates are low (relative to interest rates abroad, adjusted for risk and other factors) then the value of a currency will be below its long-run expectation. But it is not the case that expectations of decline drive up domestic interest rates--not unless a central bank is driving up domestic interest rates because it wants to keep a currency worth more than its long-run expectation. And the U.S. Federal Reserve is not in the business of pushing up domestic interest rates in order to keep the value of the dollar high.

So how then is it that Buiter expects "the weakness of the dollar, and fear of its future weakening" will "trigger a large increase in long-term US interest rates"?

One possibility is the following chain of causation:

  • Past declines in the value of the dollar push up import prices.
  • Rising import prices produce inflation.
  • Existing inflation leads workers, managers, and savers to expect future inflation.
  • The Federal Reserve has to raise interest rates to create mass unemployment to keep those expectations of future inflation from turning into actual high inflation.

But there seems to be another line of argument back there: one in which demand for dollar-denominated bonds is diminished by the mere fact that they have been a money-losing asset class in the past, and that this is a source of excess volatility in the currency markets. Such excess volatility is a bad thing for U.S. consumers of imports--they will face lousy terms of trade. It is a good thing for U.S. manufacturing companies and their workers. It is probably a small net minus for the country as a whole. However, it is not enough of a net minus to justify the Federal Reserve hitting the economy on the head with a brick--raising interest rates to recessionary levels--in order to prop up the value of the dollar.

The potential problem is only if rising import prices make people scared of rapidly-rising inflation. This makes me think that a suggestion Greg Mankiw made once--that the Federal Reserve should focus on and disseminate not core inflation--inflation ex food ex energy--but supercore inflation--inflation ex food ex energy ex imports.