TCS Daily


By Arnold Kling - June 19, 2003 12:00 AM

"The Teflon-like resistance of the US dollar is yet another manifestation of this pervasive sense of denial. Currencies, of course, are relative prices. And in a synchronous global recession everyone gets hurt. Yet if a US-centric world tumbles into recession, goes the logic, the dollar is still viewed as the 'tallest pygmy.'"
-Steve Roach

Morgan Stanley's Steve Roach is one of many economists to have noticed what might be called the "dollar bubble." The dollar is overvalued relative to fundamentals. The manifestation of this is the large U.S. trade deficit. Net investment from abroad (the difference between U.S. assets purchased by foreigners and foreign assets purchased by U.S. investors) is rising. As a result, foreign investors are accumulating an ever-increasing amount of U.S. assets relative to our GDP.

For some nice charts and alarmist analysis of the relationship between foreign investment and the trade deficit, see this post by a blogger named "billmon". I think that billmon is using the standard liberal forecasting model, which predicts disaster based on the following logic: America is bad. George Bush is a doo-doo head. Just watch. Bad things are going to happen to America. Regardless of how that forecasting model turns out, I think that billmon's charts are accurate.

At some point, foreign investment in the U.S. will slow down. This will cause a decline in the value of the dollar (in fact, the dollar already has slipped this year). At some point, our trade deficit will start to diminish. If the dollar falls far enough, we might even enjoy a trade surplus.

Screwed Either Way

Even though the dollar is overvalued, it is impossible for the United States to suffer a currency crisis of the sort experienced by Asian countries in the late 1990's or Latin American countries seemingly once a decade. The reason is that the United States has the luxury of having its debts denominated in its own currency.

When another country -- say, Argentina -- builds up a large foreign debt, that debt is denominated in dollars. Therefore, when the crunch comes and Argentina's peso declines in value, the cost of the debt increases. Argentina's borrowers, who can no longer afford to pay in dollars when their earnings come in pesos, are screwed.

On the other hand, when the United States suffers a currency decline, it does not affect the domestic value of our debt. We can still afford to pay in dollars. Foreign lenders, who find that they have lost purchasing power when they convert our payments to local currency, are screwed.

The beauty of having dollar-denominated debts in a world of currency fluctuations is that the United States is fairly insulated. If the foreign currency crashes, foreign borrowers take the hit. If the dollar crashes, foreign lenders take the hit. Foreigners are screwed either way.

The Safe Haven

Why do foreign investors invest so heavily in dollar-denominated assets and bear the risk of a decline in the dollar? Personally, I think it is because they are stupid. But that is not an appropriate answer for an economist to give.

If I were forced to pick an economic theory to explain the dollar bubble, it would be the theory of the safe haven. In a world of political and economic turmoil, America's securities represent a stable store of value. Are you a Saudi worried about the viability of the regime? Buy U.S. securities. Are you a citizen of a former Soviet republic trying to keep the criminals and kleptocrats away from your savings? Buy U.S. securities. Are you a European who is pessimistic about the prospects for the welfare state? You get the idea.

Foreigners, like our own domestic liberals, talk about the U.S. as if it were going to hell in a handbasket. But when they make decisions with their money, it turns out that they are even more worried about the prospects in their own countries, including the leadership of their own doo-doo heads. Like Steve Roach, they concede that the American economy is the "tallest pygmy."

The Bond Bubble

The safest of all the save havens would be U.S. Treasury securities. Otherwise, it becomes difficult to explain how long-term interest rates in this country have continued to decline. This is the opposite of what the critics are saying should be happening, given those enormous, irresponsible tax cuts and big deficits and all.

The mystery is why there is so little expected inflation built into the yields on long-term bonds. J. Huston McCulloch, an expert at extracting the term structure of implied expected inflation by comparing the yields on ordinary (nominal) bonds with inflation-indexed securities (TIPS), recently reviewed a survey of inflation forecasts and concluded,
"10-year TIPS [inflation-indexed Treasury securities] therefore have a higher expected return, in either real or nominal terms, than nominal notes of similar maturity, for every one of the 34 forecasters polled. At the same time, the indexed notes are essentially risk-free to their respective maturities, while the inflation risk on 10-year nominals is considerable. This is what is known in the economics literature as second order stochastic dominance. This means that no informed rational risk-averse investor with these inflationary expectations should be investing in the nominal notes when the indexed notes are available at current rates."

Translated from academic-speak, McCulloch is calling investors stupid for buying nominal Treasury securities. If "stupid" is too strong a word, we could use the euphemism "foreign," which is reasonably accurate, as billmon shows in his charts.


If you are a speculator, then the dollar bubble and the bond bubble represent interesting opportunities. I think that there is a lot to be said for over-weighting your portfolio in favor of TIPS and in favor of securities denominated in foreign currency. A real risk-taker might play the interest-rate or foreign-currency futures markets (you would short the dollar and short long-term U.S. bonds), but then even if I'm right about the bubbles you could face the gambler's ruin problem: before the markets return to the levels that I believe are consistent with underlying fundamentals, you could have gone bankrupt.

If you are waiting for a financial-market disaster to come crashing down on the evil Americans and their evil Republican administration, I would not hold your breath. If the dollar bubble bursts, it will reduce our wealth a bit (because of the rise in the cost of foreign goods), but the improvement in our trade competitiveness will help to increase output and employment.

Bursting the bond bubble would lead to higher interest rates on Treasury securities. For that to happen, something has to occur to revive concern about inflation. Concerns about inflation will rise when the economy has settled into a solid recovery, which would alleviate another silly doomsday scenario -- deflation.

Robert Solow, in an excellent article about the incentive of economic pundits to forecast improbable disasters, concludes, "If the economy recovers next year of its own accord, it is a fair bet inflation will soon be the panic of the month." I think that a recovery and a revival of inflationary expectations is something to worry about if you are a bond investor. But it would not be bad news for the administration.

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