The slide of the dollar seems a matter of indifference to most Americans. (Visiting Washington a few years ago, I was surprised to find that the dollar-euro exchange rate could only be found deeply buried in the financial pages of the WAPO; in France, it’s included in the hourly financial news bulletin on the main radio news channel. This is absurd, but shows the sensitivity bred by the decades of pre-euro vulnerability.) Even an expert like Brad DeLong highlights the one-hand fact that the fall has raised the dollar value of American assets abroad by $400 billion. Me, I’d worry a bit more about the other-hand consequence that the value of foreign assets in the USA has gone down by even more, and the holders are in a position to do something unpleasant about it: sell.
Is a run on the dollar possible?
The conventional wisdom has it that speculative attacks on a currency are basically a problem with pegged rates. In the right circumstances (which are not rare) they create one-way bets for the likes of George Soros. The solution is to float (or irrevocably fix in a currency union). As a categorical assertion, this commits the fallacy of the excluded middle here: pegged rates are vulnerable to runs, ergo floating rates are always safe. They are safer, but do the floating prices of stockmarkets protect investors from the risk of bubbles and crashes? In the right circumstances – which will be rare – surely a floating currency can be subject to a run, a panic in which many investors bolt together for the exit because they believe that others are doing so.
The USA finds itself, by the combined thriftlessness of its government and its consumers, in a deep debt hole. In 2005, US net indebtedness was $2.7 trillion. Foreigners held $2.4 trn in liquid government securities, and $2.1 trn of equities. The majority of the government securities are held by government agencies such as central banks, the majority of equities by the private sector (here, table 1.6). With the current account deficit running at ca. $800bn a year, the current figures are that much higher. US GDP is running at $12.5 trn so the annual deficit is 6% or so of GDP, or 2 years’ growth; the net indebtedness 30% or so.
It’ s CW that the former is unsustainable. What about the latter? The likeliest scenario is perhaps the rosy one: the US still offers a vast range of investment opportunities to foreigners, and where else can they put their savings, including trade surpluses? But suppose a fraction are upset by the losses they have suffered, conclude that the dollar still has a long way to fall, and start selling; or a sharp decline is triggered by hedge funds, and bond and equity-holders lose their nerve and panic. Private-sector holdings would be quite enough: the likely rebalancing of reserves away from dollars by central banks will further the current decline, but I can’t see them joining in the run.
A run on the dollar today would have to be on a catastrophic scale, never seen before. But catastrophes do happen. The forced exit of the pound sterling from the ERM in 1992 (“Black Wednesday“) cost British taxpayers Â£3.3 billion, mainly in lost appreciation of currency reserves. George Soros alone shorted the pound by $10 billion. Taking 25% as the devaluation (Â£1=DM 2.95 to DM 2.20), the total speculative sales must have been of the order of Â£13bn, or $25bn at today’s exchange rates. That’s chickenfeed in today’s financial markets. A run of $500 billion on the dollar, only 10% of total foreign assets in the USA, would be unmanageable; US government foreign currency reserves are only $66 billion, not much more than the $52 billion claimed by Iran. BTW, wouldn’t you expect Iran to be drawing up contingency plans for sparking a run to deter US military adventures?
The Fed would have to close the markets, after vainly hiking overnight borrowing rates to – what? 50%? Then the men in black – Rodrigo Rato, Jean-Claude Trichet, Zhou Xiaochuan – would show up with generous offers of help to calm the markets when they reopened, contingent on lectures on financial responsibility and a few minor policy adjustments – say a $1 a gallon tax on gas, the repeal of Bush’s tax cuts, and a 2-year increase in the pension age, effective immediately.
Americans, both policymakers and citizens, would I think be quite unprepared for this situation. It’s humiliating, but many other countries, including the UK, have had to endure it, and sympathy will be in short supply. The many financial panics in American history have been essentially domestic affairs.
The realization of dependence on the rest of the world in this way would be a most unpleasant awakening. I hope it happens more gently, but one way or the other, it surely will.
8 thoughts on “â‚¬1 = $1.33”
You're not from the U.S., are you?
Americans are *not* going to permit foreigners to set U.S. monetary and fiscal policy. It's much more likely that we'd simply repudiate the debt – even if it meant destabilizing the international capitalist system.
No politician could go back to his district and explain that he had voted for a $1 gas tax because the Chinese said to. It would be a road to instant electoral defeat. Frankly, I wouldn't rule out an armed uprising, or at the very least mobs aimed at Chinese in America.
Repudiating the debt wouldn't really help–the US balance of payments is way negative without the capital account–without the help of foreigners the US has no way of maintaining its current level of consumption, and certainly no way of sustaining the value of the dollar. People might be willing to pay a $1 gas tax if they thought that otherwise gas prices would double because the dollar was worth half what it had been two weeks earlier; it wouldn't have to be sold as a concession to foreigners, but as a concession to reality, not that Americans like those either.
What continues to keep this from happening is that foreign central bankers are not anxious to have to deal with the consequences within their own countries of a US currency implosion. The US is simply much more important to the global economy than Britain was or is, and no one wants to rock the boat, because everyone knows it could capsize.
That said, few people (who have thought about it) believe the current situation is sustainable, so eventually something dangerous will happen. Unsurprisingly, policy makers in all countries want to put this off until someone else is in office.
I'd sure like to know where that "vast range of investment opportunities" is in the US – for all of the ballyhoo surrounding the "new all-time highs" in the Dow Industrial Index, after factoring in the 9% depreciation in the US$ this year the ROI in US equities has been barely 3-4%. Most of the real action has been in the credit and debt markets, which is where the major financial institutions have been raking in the dough with their ever-expanding pyramid of derivative instruments.
This is where the real danger lies – in the hyper-leveraged positions held by hedge fund speculators and international investors. The Fed has completely failed in its policy of trying to shrink liquidity gradually through "baby-step" interest rate hikes – instead, we got an even greater liquidity spike as the "hot money" started shifting out of the collapsing residential housing markets and into commercial real estate, corporate junk bonds, etc. Never in the course of human history have so many been exposed to so much long-term risk without even being aware of it.
Perhaps I'm confused here, but the discussion seems to conflate issues about selling off assets denominated in dollars with issues about selling off the dollars themselves. What killed so many other debtor nations was debt denominated in currencies other than their own, so that they had to pay real money for interest and principal.
Simply selling off dollar-denominated assets for more dollars doesn't do hedgers any good; they have to either get out entirely or into us-based assets that they think will hold their value in the event of a run. Refusing to take dollars for exports (or to buy more dollar-denominated credit, which amount to the same thing) would be disastrous for the US, but then what?
A few observations to throw into the mix:
If the current-account deficit is unsustainable (as everyone seems to think it is, myself included), I don't see what's going to move the currency market. As it works now, it responds only to small relative interest-rate differences; exchange rates just don't seem to move on anything else, least of all on fundamentals.
Some moves may, once started, seem to reflect fundamentals, but they're not set off by fundamental factors. This recent move, for example, seems to have been set off by a combination of an ECB rate hike and indications of further US economic weakness, implying slower growth, implying static or lower interest rates. It may *seem* to be a fundamentals-based move, but if it was, why did it reverse on Bernanke's inflation talk?
Sort of apropos, I think Matt Wilbert is right that nobody wants a fundamental adjustment to happen on bush's watch. He's nuke-crazy, if not just completely crazy, and nobody wants to get bombarded. Maybe that has some effect on the currency markets.
The indicator I'm watching for is when we in the US will actually need to earn foreign exchange. That strikes me as one of the great perils of pricing oil in euros, as several oil producers have been moving toward doing. The world will change on that day, and not in a comfortable way for us here. I'm not confident that bush or anyone he listens to understands that or cares.
"The indicator I'm watching for is when we in the US will actually need to earn foreign exchange."
Altoid, I think you make a crucial point. The US has benefitted for many years from seigneurage (I love that word) — the readiness of foreigners to use the dollar as a store of value. The US Treasury gets a permanent free loan from seigneurage.
But it could come to an end. If oil sellers start demanding Euros or some other currency, if foreign lenders indicate that they'll only buy US debt denominated in foreign currency, a la Mexico, then the US will have lost a valuable asset. And once lost, I doubt we'd get it back. The British pound used to be a store of value for half the world, but those days are gone, never to return.
How would we earn a surplus in foreign currency to buy oil with? Sell more wheat and Boeing airplanes, I guess, but mainly buy fewer imports. It's going to hurt.
"Seigneurage"? Wouldn't you know the economists would have a term for it! Thanks, Hal–
You know that repudiating debt is explicitly forbidden by the Constitution, don't you?
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