Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

C'est la vie; c'est la guerre; c'est la pomme de terre . . . . . . . . . . . . . email: jpalmer at uwo dot ca

. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Sunday, December 18, 2005

Depreciation of the U.S. Dollar:
a question of "when", not "if"

The U.S. dollar has remained strong during the fourth quarter of 2005 despite continuing trade and U.S. federal gubmnt deficits. There are two related reasons for its continued strength:
  • Anticipated continued tightening by the Fed, albeit at a slower pace, has kept U.S. interest rates attractive for foreign (and U.S.) short-term financial capital.
  • Continued unease about international politics makes the U.S. economy seem less risky than many other options. As I asked last spring, "Where else would you put your money?" I realize there are many options, but just how risky and how attractive are they?
Ben Carliner pointed out last month that the strength of the U.S. dollar is not likely to persist:
Well, in the short term at least, America’s twin deficits just don’t seem to matter. The markets’ attention is elsewhere, and for much of the world, continued economic growth is predicated and strong US demand. Unfortunately, in the long run, current account deficits do matter, and putting off the day of reckoning will make the correction, when it does come, all the harder.
Nouriel Roubini has a similar outlook:
In 2006 the structural medium term factor that will tend to weaken the dollar - the large and growing US current account deficit - will reassert its role while the short term cyclical factors that have lifted the dollar this year will tend to weaken their effect. So, at the end you cannot fight the laws of gravity as the cyclical forces that have defied such gravity are temporary while the forces that will cause a gravitational fall of the US dollar are as strong as ever.
However, Brad Setzer suggests that maybe the rest of the world is willing to keep financing the U.S. twin deficits for quite some time:
Of course, the US can only spend more than it earns so long as the rest of the world is willing to finance the US.

And the People's Bank of China is certainly aware of that it will take large losses on its dollar portfolio if it continues to finance the US. Last I checked, Yu Yongding sits on the PBoC's monetary policy committee, and he was pretty clear about this in a recent speech.
... So far, though, Yu has not convinced the Chinese government to cut back on its reserve accumulation: Chinese reserve accumulation has grown every year since 2000. And so long as China, Russia and Saudi Arabia's central banks are as willing as the markets to finance the US - if not more willing - the US seems set to keep on spending.
So when will they stop, if ever?

For a set of invaluable links and references on the economics of foreign exchange rates, see this post at The New Economist.
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