Yesterday’s dollar plunge unnerved markets. What’s the likelihood of a sustained, drastic decline?
Figure 1: USD/EUR daily exchange rate, up to 24 November 2006. Source: St. Louis Fed FRED.
One of the enduring oddities of the international economy is the willingness of foreign investors — both private, official, and quasi-state — to hold dollar assets despite the very low returns on such assets, even when comparing in common currency terms. It is this anomaly that Krugman disucusses in an academic paper asessening the possibility of a dollar crisis.
“Concerns about a dollar crisis can be divided into two questions: Will there be a plunge in the dollar? Will this plunge have nasty macroeconomic consequences?
The answer to the first question depends on whether there is investor myopia, a failure to take into account the requirement that the dollar eventually fall enough to stabilize U.S. external debt at a feasible level. Although it’s always dangerous to secondguess
markets, the data do seem to suggest such myopia: it’s hard to reconcile the willingness of investors to hold dollar assets with a very small premium in real interest rates with the apparent necessity for fairly rapid dollar decline to contain growing foreign
debt. The various rationales and rationalizations for the U.S. current account deficit that have been advanced in recent years don’t seem to help us avoid the conclusion that investors aren’t taking the need for future dollar decline into account. So it seems likely that there will be a Wile E. Coyote moment when investors realize
that the dollar’s value doesn’t make sense, and that value plunges.”
The presumption that there is investor myopia means that median measures of exchange rate expectations might provide very inaccurate indicators of what will happen in the future. Right now, typical forecasts are for gradual dollar depreciation — 8 percent over the next twelve months (in log terms) from November 17th, according to DeutscheBank. The USD/EUR rate is forecasted to depreciate by 5.3 percent. In contrast, the Economist reports JP Morgan forecast of zero USD/EUR depreciation over the next year from November 23rd.
Investor myopia might explain — or at least is consistent with — the finding that uncovered interest parity (UIP) doesn’t hold. Indeed, the failure of UIP is one reason why the “carry trade” is so profitable [see Mike Rosenberg's (Bloomberg) discussion of the long standing nature of carry trade profitability at the end of this chapter]. Of course, in a portfolio balance model common currency returns need not be equalized. But the extent to which the rate of return on USD denominated assets is less than those on other assets is too large to be rationalized by standard portfolio balance models.
On the second question posed, Krugman is much more sanguine. Since balance sheet effects are not relevant(or more accurately, work to the benefit of the US via valuation effects), the dollar decline should have a net positive effect on aggregate demand via expenditure switching. This view is buttressed by the empirical work of Croke et al. (2005) as well as Freund and Warnock (2005).
He is a little less optimistic about avoiding a slump if the current strength of the dollar is due to investor myopia, and housing prices exceed those consistent with rationality and the transversality condition (for instance, if there is a bubble). A downward revision in both the relative market-to-book price (i.e., “q“) of housing as well as the value of the dollar might induce a slump if the lags in adjustment to the exchange rate are longer than those to housing prices. My own view is that is likely to be the case.
Indeed, the lags to exchange rate changes are more likely to be longer, the harder it is to move capital and labor to the export sector. After the battering taken by the tradable sector over the past decade, I worry.