About


The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


« Why Thinking About The Dollar Makes My Head Hurt | Main | The Chinese Central Bank Back In Action (Sort Of) »

September 22, 2005


The Third Way On The Effects Of Dollar Depreciation

Yesterday I took note of the push and pull forces that are making it awfully hard to predict where short term momentum is for the dollar (and trade deficit) in the current global economic environment.  It does, nonetheless, seem indisputable that the longer term forces are firmly in in the direction of reversal in the U.S. current account deficit, and (probably) an associated decline in the value of the dollar. Thus we find our way to the now familiar hard-landing/soft-landing debate.

Brad DeLong weighed in on this just last week -- in a post heartily endorsed at winterspeak -- putting his chips on the soft-landing side of the table:

The domestic macroeconomists would typically argue more or less like this:

Yes, the dollar is likely to decline steeply either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both. But so what? The fall in the value of the dollar will boost foreign demand for U.S. exports. Workers will be pulled out of other sectors into the export sector. The effects of the dollar decline are much more likely to be a plus for employment rather than a minus, a boom rather than a recession.

To this, the international economists would respond more-or-less like this:

When foreign central banks stop buying or international speculators lose confidence in the value of the dollar and thus stop buying U.S. long-term bonds, two things happen: the value of the dollar falls, and the rate of interest on dollar-denominated long-term bonds spikes. The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth. The fall in domestic spending happens now. The rise in exports as the falling dollar makes U.S.-made products more attractive to foreigners happens two years from now. In between, a lot of people are unemployed--and as they are unemployed, they cut back further on their spending. Plus there is the risk that the fall in the value of the dollar and the fall in long-term asset prices generated by the interest rate spike will cause enough bankruptcies among financial institutions to cause a flight to quality--which will further raise non-safe interest rates, and further discourage investment and consumption spending.

I find myself in an odd position here.  I agree with the "domestic macroeconomists" conclusion, but am sympathetic to much of the "international economists" reasoning.  I have a third way. Let's call it the "full employment economists" story:

Yes, the dollar is likely to decline either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both.  The result will be a reduction in the flow of imports into the U.S. that have been allowing consumers, firms, and the government in the U.S. to consume more than the domestic economy is producing.  Without the extra goods and services from foreigners, prices have to adjust to bring domestic demand in the U.S. back into line with supply.  In fact, demand from U.S. consumers, firms, and the government have to fall by even more than that, because export demand will pick up when the dollar depreciates.  The prices that make it all happen are real interest rates, so you better expect that they will rise.

All of this requires a fair amount of resource reallocation, which is always a bit tricky.  But if the process is slow enough and smooth enough, there really isn't any reason to believe that there will be a big impact on U.S. GDP and employment growth, one way or the other.

That's my story, and I'm sticking with it.

September 22, 2005 in Exchange Rates and the Dollar , Interest Rates | Permalink

TrackBack

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d8341c834f53ef00d8345818df53ef

Listed below are links to blogs that reference The Third Way On The Effects Of Dollar Depreciation :

Comments

Let me offer a way to reconcile your third way with the other two theories. And, at the same time, fit in your concerns about the near term outlook for the USD!

Think about the path of adjustment towards an eventual equilibrium. In today's world, excess demand shows up in C/A imbalances.

The presistence of these imbalances means growth has been surprisingly resilient, reducing the amount of global excess capacity (note the recent acceleration in Chinese wage inflation). And,hence more potential for accelerated wage and price inflation. (Katrina may well have added to this process directly in the US.)

All this may be associated with an initial USD drop (Chinese less willing to allow domestic inflation to rise and tighten via the currency). But, it may not. Say, if inflation pressures show up in US first (where the excess demand resides!). Which comes first will help determine the path. I'm not sure of the answer here.

But, in either case, price increases start to emerge, importantly in the US. And, price increases are part of the rationing process.

As are interest rate hikes. Both seem likely to take place during this alternative adjustment path.

Its only after this process begins, that we will move on to the hard/soft landing issue. I've always been a hard lander, but I also can see that if inflation accelerates, then real house price adjustment can occur with limited nominal ajdustment, and thus perhaps less overall dislocation in the US. A smoother slowing would emerge in US domestic amd import demand.

In this little model, we might get a RISE in the USD first. And, it is when the economy starts to adjust AFTER the inflationary spurt, that the USD really runs into trouble. When the USD loses interest rate support.

You see, it is possible to be a deflationist, and see tears at the end of all these historic imbalances. Yet, it is also possible that this will be a very bumpy path which includes an inflation spurt and maybe even a USD rally.

AFter all, the 1970's adjustment was very bumpy and volitile. So, why expect developments towards deflation and/or eventual USD collapse to be smooth and immediate?

We are so impatient!

Posted by: andres | September 22, 2005 at 09:31 AM

Let me offer a way to reconcile your third way with the other two theories. And, at the same time, fit in your concerns about the near term outlook for the USD!

Think about the path of adjustment towards an eventual equilibrium. In today's world, excess demand shows up in C/A imbalances.

The presistence of these imbalances means growth has been surprisingly resilient, reducing the amount of global excess capacity (note the recent acceleration in Chinese wage inflation). And,hence more potential for accelerated wage and price inflation. (Katrina may well have added to this process directly in the US.)

All this may be associated with an initial USD drop (Chinese less willing to allow domestic inflation to rise and tighten via the currency). But, it may not. Say, if inflation pressures show up in US first (where the excess demand resides!). Which comes first will help determine the path. I'm not sure of the answer here.

But, in either case, price increases start to emerge, importantly in the US. And, price increases are part of the rationing process.

As are interest rate hikes. Both seem likely to take place during this alternative adjustment path.

Its only after this process begins, that we will move on to the hard/soft landing issue. I've always been a hard lander, but I also can see that if inflation accelerates, then real house price adjustment can occur with limited nominal ajdustment, and thus perhaps less overall dislocation in the US. A smoother slowing would emerge in US domestic amd import demand.

In this little model, we might get a RISE in the USD first. And, it is when the economy starts to adjust AFTER the inflationary spurt, that the USD really runs into trouble. When the USD loses interest rate support.

You see, it is possible to be a deflationist, and see tears at the end of all these historic imbalances. Yet, it is also possible that this will be a very bumpy path which includes an inflation spurt and maybe even a USD rally.

AFter all, the 1970's adjustment was very bumpy and volitile. So, why expect developments towards deflation and/or eventual USD collapse to be smooth and immediate?

We are so impatient!

Posted by: andres | September 22, 2005 at 09:36 AM

I am not sure any of this has to happen soon. Most attractive to foreigners are American assets, particularly companies. If they went on spending spree, prices could remain low for a long time to generate cash for these purchases and they would also gain improved margins from their purchases. Their moves have been hesitating and faulty but they are heading in this direction.

Posted by: Lord | September 22, 2005 at 02:03 PM

well, there is little evidence foreigners are especially attracted to US assets. US equities have been underperforming for years. And, more recently, so too have bonds.

So, there is more demand for US assets than maybe many of us would have expected. Bonds have held up surprisingly well and, to many, so too have US equities. But, they've still badly lagged the rest of the world.

Very much unlike the 1990's when private capital was indeed flowing strongly into the US.

Instead, what holds up the USD I think is central bank money and 'hot'-type money, attracted to the front end 'carry' game.

And, When i talk to investor types abroad, their fear is losses on US assets (eg, biggest question for foreign central banks is about Agency debt!).

Posted by: andres | September 22, 2005 at 06:57 PM

First, I would like to stress that the domestic versus international economists points of view, sounds more like the producer versus banker antagonism.

IMHO, in order to understand where we stand, one has to consider 3 major issues, namely;

* low wages in China, and the consequent erosion to employment and investment in the US.

Let's get this straight, investors are either investing in China (or close by) or they are going to hold to their cash, preferably in foreign currency, till conditions are ripe for investment in the US --not a moment sooner.

And, conditions will be ripe when the US dollar has weakened --so there is more bang for the Yen, Euro invested in the US-- and US wages are more competitive, and it makes sense to invest in US manufacturing.

* US government deficit. War and others...

* High oil prices, or an energy shortage gap.

Let's go back a little. I don't think foreign central bank purchases of US bonds are going to disappear overnight, as suggested. Foreign CBs are fiercely protecting their local employment, at the tone of 100s of billions of dollars. I would call it the cost to acquire market share.

Furthermore, let's not forget the gargantuan political pressures behind the 100s of millions of voter-workers to Chinese and Indian leaders.

As a matter of fact, isn't this the cause for the Greenspin conundrum; the Fed pushing up short term rates and the foreign CBs pushing down long term rates?

So foreign CBs are aligned with producers --and workers--, and Mr. Greenspin is either aligned with the bankers protecting the value of the US dollar, or he is making one hell of a doodoo by raising interest rates.

I'm inclined to believe it's a doodoo.

My reasoning is US wages have to fall --there is no other way out of the slow grinding erosion of jobs and US manufacturing. Which clearly is the only way to correct the CA deficit...and I underscore --the only way!

Listen, the Fed can play their games, lower the Fed rate, lower the reserves...and it's not going to make a difference in the end; US wages have to fall to counter Chinese low wages!

The palatable and easy way to lower wages is to allow the US dollar to drop. The alternative, to raise the US dollar, will also render lower US wages in a much meaner way--the acceleration in the erosion of US jobs will take care of that.

Now, let's stop for a minute to consider this last alternative, every day that goes by with high US wages, means factories are closing in the US and are opening abroad. Will the US be able to recover this lost market share? The US has to move quickly and decisively in the right direction. Why give it all away? So bankers can be happy with a strong US dollar? It's bound to hurt them too soon enough...

BTW, Inflation should be harsher in China than the US, the raw material cost component is larger since their labor component is lower. For instance, high oil prices are hitting much harder China than the US --not withstanding subsidies effects.

So, these are the issues dragging the US economy, or more precisely, the CA. Improvements will come to the US economy when steps are taken to correct these issues.

So we should be asking ourselves:

* Is the Fed allowing the US dollar to fall, in order to foster competitive US wages?
* Is the government reducing its expenditures?
* Are oil prices under control?

Hello...hello...anybody home...at the Treasury or the Fed, or the executive??

Mind you, the US dollar will fall inevitably, it's the answer to the 3 questions...

If the war in Iraq ends, that would be a boost. How about it Mr. Bush?

Oil? Let the Treasury short the energy markets... the Fed fools around with billions, let the Treasury strike force attack the energy crisis...

Just my 2 cents.

Posted by: Joe Rotger | September 22, 2005 at 11:46 PM

A couple of comments.

Economists tend to portray inflation as evil. I disagree, this is not always the case.

During the 70s petrodollars returned to the US in the form of bond purchases, as is the case nowadays, with the Asian CBs purchases.

Inflation, or a US dollar devaluation, which are very similar, extract an enormous toll from these lenders. It would seem that inflation --or a currency devaluation-- is a counter reaction or payback correction to the inequity exerted by the initial imbalance to the CAs.

Inflation or a US dollar devaluation is positive, under the right circumstances.

If not, can anybody tell me how to correct the CA deficit --and save US manufacturing?

Posted by: Joe Rotger | September 23, 2005 at 12:18 AM

Call me naive, but whose's to say that the US can't have its cake and eat it too? If Ben Bernanke is right about the global savings glut(and I think he is), doesn't that make a strong case for a much more benign current account adjustment in the US? Other than a weaker dollar and somewhat higher interest rates, it would seem that any impact to GDP growth would/could be minimal (sort of like the Reversal 2% that Edwards tests).

Posted by: John_Bott | September 23, 2005 at 09:24 AM

" And, When i talk to investor types abroad, their fear is losses on US assets (eg, biggest question for foreign central banks is about Agency debt!). "

As far as I can tell, they're well covered; although, getting rid of all the foreclosed property held as collateral to their mortgage backed securities may be a stickier issue --or slow to liquidation.

Posted by: Joe Rotger | September 23, 2005 at 10:51 AM

Mine is a question. As stated above: "The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth."

My understanding of recent economic events is that US consumer spending has kept the world economy afloat via the informal Breton Woods II arrangement. If consumer spending slows, as it appears it must via various means not the least of which is the depreciation of the dollar, would this not negate the BWII arrangement and thereby slow the world economy? Perhaps to the point of a prolonged recession?

Thanks for any help.

Posted by: John | September 23, 2005 at 12:47 PM

Post a comment

Comments are moderated and will not appear until the moderator has approved them.

If you have a TypeKey or TypePad account, please Sign in

Google Search



Recent Posts


Archives


Categories


Powered by TypePad