How Main St. and Wall St. Will Feel as the Dollar Plunges
By EDMUND L. ANDREWS
Published: February 9, 2004
WASHINGTON, Feb. 8 — Treasury Secretary John W. Snow has tacitly but unmistakably abandoned Washington's longstanding support for a strong dollar in favor of a weak dollar that is getting weaker, though he continues to insist there has been no change in policy,
Stripped of the code words and elliptical references to "excessive volatility" in exchange rates, the message that Mr. Snow delivered this weekend to finance ministers from Europe and Japan was that the dollar's plunge against the euro is just fine and that the dollar should now decline more rapidly against Asian currencies as well.
In so doing, the Bush administration has made a calculated economic and political choice. By condoning and even encouraging a cheap dollar, the administration is providing a big push to American exporters by making their products less expensive in foreign markets.
That should encourage more hiring and lower unemployment leading up to the election. The only immediate losers are exporters in Europe and Asia who have to choose between cutting prices or losing market share in the United States.
But the long-term risks are substantial. At some point, a weaker dollar will inevitably lead to higher prices for imported goods — almost all consumer electronics bought by Americans, most of their clothing, many of their cars and much of the oil that provides the fuel to drive them.
A much bigger risk is that a plunging dollar could contribute to a rise in interest rates, as foreign investors demand fatter risk premiums before agreeing to buy hundreds of billions of dollars worth of Treasury securities to finance America's high levels of indebtedness.
The United States needs to attract $1.5 billion a day in net capital inflows from abroad — $500 billion a year more than it sends out — which means that the world is being flooded by American I.O.U.'s at levels never seen before. The administration's huge budget deficits could increase that need for foreign capital even more, and higher interest rates would add billions of dollars to those deficits.
Foreign buyers, and Asian central banks in particular, are now the most important buyers of American Treasury bills and bonds. But much of that buying had little to do with the rosy economic outlook for the United States and very much to do with propping up the dollar against the Japanese yen and the Chinese yuan.
The dollar would probably be declining regardless of what Mr. Snow said, because the United States is now so indebted to the rest of the world that the appeal of American securities is considerably less than it was at the height of the boom.
Posted by P6 at February 9, 2004 08:24 AM
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Comments
The article is generally correct, although it makes the popular slip of equating an internal deficit (the $500+ billion thing Bush hath wrought) with the external deficit (our current account deficit). Neither is the same as the Balance of Payments deficit (which is =Current Account Balance + Capital Account Balance).
The value of the dollar is affected by the Balance of Payments (BoP) and the Capital Account balance (KAB); if the latter falls, the former increases, and the demand for eurodollars must either grow or the US dollar will decline.
This is very unnerving, because if the US dollar declines precipitously, then FDI in the US will fall too, leading to a decline in the KAB surplus; in my research, this will cause the dollar-denominated current account balance (CAB) deficit to become larger.* So, to sum up: dollar down (a lot); KAB surplus, down; CAB deficit, up; BoP deficit, up (a lot!!); this pushes the dollar down some more, and so on.
The brake on this is that the price of oil and some other commodities is dollar denominated.
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* My allegation that US imports (in dollars) increase as the dollar increases, contradicts what is said on news reports all the time; yet it's actually well established in basic open economy macro. In theory, there is a price elasticity for imports and for exports, and if the sum of the elasticities >1, then a reduction in the exchange rate of the US dollar will lead to an increase in exports and an increase in imports. That state of affairs is called the "Marshall-Lerner Condition." It DOES NOT apply to the USA. Historically, the price elasticity for imports and exports has been far less than one.
Anyone who thinks I am being delusional can email me and request a spreadsheet in which I regressed the historical data. It's in Excel and you should understand regression analysis.
Posted by James R MacLean at February 9, 2004 05:21 PMI'll probably have a question tomorrow when I get the definions of the terms of art squared away.
Posted by P6 at February 9, 2004 07:22 PMOkay, FDI = Foreign Direct Investment, right? If so, I follow you.
Posted by P6 at February 10, 2004 04:32 PMYes. Capital flows include foreign direct investment plus portfolio investement, although usually in class we just call both "FDI."
Current account balance (CAB) is net annual income from all foreign sources. This includes payments for goods & services rendered, foreign aid received, and income from assets American residents have abroad. I call this last item "foreign factor income," or FFI. It's also referred to as factor payments.
Logically you would expect the capital account balance to have CAB as its acronym, but that's taken by the current account balance. Besides, economists always abbreviate "capital" as K. The KAB represents (net foreign purchases of American securities) - (net American purchases of foreign securities). It is not national income, because even though capital flows to the USA, it doesn't belong to us. It is our liability. The KAB for the USA is +$1.5 to 2 billion daily.
If I say CAB (-$600 billion)+ KAB (550 billion) = Balance of Payments (BoP) = -$50 billion annually, you will understandably sense that I am delusional--we've accrued liabilities of 600 billion for the year, fair and square. But financial accountants treat them differently because they are different in character. Until a bond matures, it's not a current liability. A eurodollar demand deposit is a liability right now.
IIRC, eurodollar accounts are about $6 trillion or so.
Posted by James R MacLean at February 10, 2004 05:31 PMFor your viewing pleasure: an accounting sheet of international transactions for the USA. This is so clear and straightforward.
If this or the previous comment doesn't make sense let me know. I keep looking at my explanation above and thinking, "This could have been more clear...but how?"
Data is for 1999 and 2000.
Posted by James R MacLean at February 11, 2004 07:52 PMI'm reading an essay right now which explains how the CGD trap works. CGD is the process I described in my first comment and I just learned that it has a formal name.
C = currency (exchange rate)
G = growth (contingent on capital imports)
D = debt
In a country like Argentina, Brazil, or Indonesia, internal deficits (i.e., government budget deficits) translate really directly to external deficits (current account deficits) because the currency is pegged to that of their main trading partner AND lender.
Posted by James R MacLean at February 11, 2004 08:08 PMBack up a minute. I went to the top again and realied I'm not entirely clear on this:
there is a price elasticity for imports and for exports
I need to know what "price elasticity" represents that it can be quantified.
Posted by P6 at February 11, 2004 11:40 PMYes: "price elasticity of demand" (P.E.D.) is the % change in demand caused by a % change in price.
So if we increase the price of tomatoes 1% and the quantity of tomatoes sold is down 1%, then we say P.E.D. of tomatoes is -1. Under normal circumstances, P.E.D. is always negative--it's the slope of the demand curve.
This concept of elasticity applies to other things. Suppose bell peppers are a substitute for fresh tomatoes (chopped, on salads). It's probably the case that if you reduce the price of bell peppers by 10%, this will reduce the demand for tomatoes by 2%. This is a "cross elasticity of demand" of 0.2. If tomatoes and bell peppers are substitute goods, C.E.D. will be positive (meaning, they move in the same direction). If they are complementary goods (i.e., you like to use tomatoes and bell peppers together, as on a shish-kebob), then the cross elasticity of demand will be negative.
There is income elasticity--your income goes up 5%, you decide you will eat healthier food. So you buy 10% more tomatoes and your income elasticity of demand is 2 (if I.E.D. > 1 then the thing is a "superior good"; if I.E.D.
Posted by James R MacLean at February 12, 2004 12:10 AMIf I say CAB (-$600 billion)+ KAB (550 billion) = Balance of Payments (BoP) = -$50 billion annually, you will understandably sense that I am delusional--we've accrued liabilities of 600 billion for the year, fair and square. But financial accountants treat them differently because they are different in character. Until a bond matures, it's not a current liability. A eurodollar demand deposit is a liability right now.
CAB (-$600 billion) means we owe to $600 billion more foreign economies than we are due to receive from foreign economies.
Yeah, it would be hard to convince me that because our foreign property is worth $550 billion more than their domestic property that we only owe $50 billion now.
On the elasticity thing, I can see price and cross elasticity as applicable on the supply side too, but income elasticity strikes me like a fudge factor. That, and I can't figure out what the supply side equivalent would be.
Posted by P6 at February 12, 2004 05:48 PMOn the elasticity thing, I can see price and cross elasticity as applicable on the supply side too, but income elasticity strikes me like a fudge factor. That, and I can't figure out what the supply side equivalent would be.
Elasticity is simply the slope of the function. The supply elasticity for price is a seldom-used phrase, but obviously means the rate at which supply goes up as price goes up.
The supply side for income elasticities would be the slope of aggegate supply (A.S.). Strict classical economists argue that the A.S. is vertical. The evidence suggests that an increase in the rate of inflation does increase output and employment temporarily. It's the worst way to do it, but it does "work."
Posted by James R MacLean at February 12, 2004 06:51 PM