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January 12, 2005


I keep waiting for the other shoe to drop, when one of those foreign national banks supporting the US deficit decides they're tired of this game of prisoner's dilemna, and suddenly dump their US dollars on the market. There's a lot of economists on ternderhooks out their waiting for it to happen.

d+u: I wonder the same thing. Also, there doesn't seem to be a way to change typos in the title of a post. Darn.

Also, there doesn't seem to be a way to change typos in the title of a post.

Oh, that was a typo? I thought you were being clever with the "do" vs. "don't" thing.

The scary part about this is that the falling dollar is not leading to export growth. Exports actually fell in November, the period the report covers. The conventional wisdom is that as the falling dollar makes US exports cheaper and imports more expensive, US exports will grow (and imports will shrink) causing the trade deficit to decrease.

If a falling dollar isn't going to lead to rising exports, how exactly is it a good thing? It isn't. It means inflation as imports become more expensive, without the benefit of export-led growth. It is the trade balance equivalent of stagflation.

We moved a bunch of savings out of our US accounts and into my wife's Australian accounts a little over a year ago and the return has been. . substantial. It's better than investing.

I'm agnostic on currency valuations and their effects on markets because there always seems to be infinite shoes to drop.

But I'm curious about the Bush Administration's motivations for letting the dollar drop. Putting aside the ideology of "no intervention ever", is this similar to James Baker's engineered dollar drop a number of years ago. And: if exports don't rise sufficiently, what then?

Or is this dollar drop a set up to cause international investors to buy currency-cheapened U.S. equities, thereby rallying the stock market during guess-what- debate about the phase out of you-know-what New Deal program?

Of course, why would investors buy equities denominated in a falling currency? But I can't figure out whether that's my faulty logic or the Administration's.



What are we to conclude from that silly article?

This is sounding so 1980s, back when folks were fretting about the "skyrocketing trade deficits" with Japan and the Little Dragons. Seems like we weathered that "crisis" fairly well.

This graph of the US dollar vs trade deficit helps make a felixrayman's point.

Bird Dog:
People fret about alot of things, they fret about things that will never come to pass, they fret about things that do. The question is, will the deficit be a real problem? One cannot tell by looking around to see if ppl are fretting.

This is sounding so 1980s, back when folks were fretting about the "skyrocketing trade deficits" with Japan and the Little Dragons. Seems like we weathered that "crisis" fairly well.

I thought that the reason we were fretting was the (perceived) strength of Japan and if they would eclipse the US. Now, I don't think we are worrying about the perceived strength of China/India/Taiwan/SE Asian exporters, we are(or at least I am) worried about a fundamental weakness in the US economy. (I am worried that China will eclipse the US, but as a regional power, not as an economic power)

From the great link that duane gave
A 30% fall in the dollar from 1985 to 1988 was required to reduce the real trade deficit from about 3% of GDP to 1% of GDP by 1989. The dollar stayed down in that range through 1997 and the deficit stayed around 1% of GDP (except when the recession of 1990-91 pulled the deficit down to zero). Bringing down the 2004 deficit of 5.3% of GDP will require a much larger devaluation of the dollar.

I get paid in yen and I am *psyched*...

If you think about it - the national banks holding dollar currency are unlikely to dump their holdings in a mass sell off on the currency market. They won’t do it for a number of reasons (in my opinion of course).

a) When a Gov Reserve bank enters the FX market to make adjustments the effect is dramatic. A Gov Reserve bank selling its dollar holdings will absolutely crush the dollars strength – something I assume most people are uninterested in. Plus quickly selling off dollar reserves will simply add significant losses to those already incurred during the dollars downward march.

b) Many of the export based economy’s holding dollars do so to in an effort to maintain a balance between their currency and ours in an effort to ensure their products viability in our market. To sell their dollar reserves (weakening our currency) would strengthen their currency (think Japan) increasing the price of their products and perhaps weakening their economy. So Japan and China are unlikely to sell since they are export based. And the EU is unlikely to sell because they don’t want see their markets flooded with even cheaper US products.

My guess is that China will take its cues from Japan – and support the dollar in an effort to keep their exports competitively priced. This will also benefit Bush. Since US (or anyone’s) penetration into the Chinese market is somewhat irrelevant, Bush can allow the dollar to continue its bearish slide against European currency’s which will continue to help increase the likelihood of US export sales in key markets while in Asia the dollar will remain steady/slightly better (hopefully) against the Yen. Meanwhile the EU will bitch and moan about the weak dollar eroding the strength of their economy all the while mulling over selling Euros to support the dollar – an option they must seriously consider even though it has to really piss them off.

c) Counter to popular belief, private companies do not react as fast as people expect to new market conditions. Right now US materials are less expensive – think of the steel market. European manufacturers may be considering switching from more expensive European suppliers to less expensive US suppliers. But those company’s need to look at what’s available, at what prices its available at, and then make a decision to change (once they have completed any obligations they have accepted for forward deliveries).

So (god I cant believe I am going to say this) Bush’s policy may actually work out.

Toby: I really don't know enough about central banks and their reasoning to say, but I suspect you're right. But this still leaves a lot of room for concern: it's not enough for them not to sell off their dollars, they have to keep buying dollars at a pretty staggering rate in order to prevent us from having the 'hard landing' that people are afraid of. (Among other things, because we need them to keep buying our bonds to finance our ongoing deficit spending.) If they don't, bad things happen. And I think it's an open question how much longer the Asian central banks will keep doing this.

BD: our trade deficit is a lot bigger than the ones that worried us in the past, plus we were then a net creditor nation, if memory serves.

When a Gov Reserve bank enters the FX market to make adjustments the effect is dramatic.

Is that really true? Because Japan had been intervening heavily to keep the dollar up

From this article from March last year

The yen's upward march to the [yen]100-to-the-dollar milestone continues. In January we predicted an eventual rise to [yen]79 to the dollar. Japan's interventions to brake the yen's rise against the dollar have taken on massive proportions.

Over [yen]20 trillion was spent last year, and over [yen]6 trillion, or nearly as much as the prior annual record for intervention, was apparently used by the end of January. Japan's intervention to support the dollar has been increasingly ineffective since the dollar tumbled below [yen]115 last September--the result of implications that the yen might ease after a Group of Seven meeting that called for flexible exchange rates.

(the next article says 20 trillion yen is about 185 billion dollars which means that they are figuring on a dollar equalling 108 yen)

Here's an Economist article saying the same thing.

And here's a business week article that makes the same point.

Now, my grasp of economics is pretty weak at the best of times, but I remember reading about this buying and thinking 'Geez, the Japanese government is pissing its money away'

Having said that, I agree with your other points about product vaiability and the likelihood off a dollar dump. however, it is getting to be more and more like Mutually Assured Destruction

LJ: We don't see the results as dramatic because they've become the status quo: Asian central banks in particular have been propping up our currency for several years. As far as the MAD analogy: you're not alone in thinking of this analogy, and worse, some of the other people who have thought of it are fairly serious economists, like Larry Summers, who refers to this as a "balance of financial terror."

What I cannot understand is why more people are not extremely nervous about letting the US economy depend so heavily on other governments, like China. It's bad enough that our dependence on Saudi oil basically distorts our policy towards them and the rest of the Middle East; now we want to allow a similar dependence, and a similar distortion, to take place with respect the China? I cannot imagine why more people don't find this idea really scary.

Sorry - guess I should qualify part of what I said.

When you are a trader and a Fed bank enters the foray the resulting spike (movement) with the currency in play is dramatic.

I haven’t been trading in 4 years now and don’t pay attention to the markets like I used to. But here's my .02

BOJ has (perhaps had) a particular trade range they like to keep the Yen in - and at 102.92/1 (JPY/USD) the JPY is probably a little outside of where the BOJ would like to see it. When I was trading the Yen was anywhere from 90/1 to 130/1. From what I remember (which sadly is very little due to numerous reasons) the Japanese like to keep the Yen around 120 to the dollar. That may have changed over the past 4 years.

Now with the dollars slide the BOJ is probably the only bank consistently trying to intervene on the dollars behalf. The dollars strength just means too much to Japans export economy. If the dollar becomes too weak their economy will suffer. But the BOJ’s intervention will only help the Yen it will not support the dollar against EU, AUD, CAD, GBP etc.

The other problem is that BOJ is probably the only national bank in the G8 that is consistently tinkering in the FX market. I think the EU (based upon what I haven’t seen in the business section off the Washington Post) has been taking a lets see what is going to happen approach to with the dollar. I assume part of that is true because of the transition of the governing body from Germany to France?

Anyway - The EURO was well undervalued. And now I think the EURO is well overvalued largely because Bush is letting the dollar slide (something I don’t like but understand their reasoning).

Without the EU's intervention the BOJ intervention only supports the dollar against the Yen so the dollar continues to slide against the EU, GBP, AUD, and CAD - something we hear an awful lot about. The dollar is weak against the Yen but still in better position because of the BOJ’ tinkering.

At some point the EU is going to have to address the dollars slide. Because if it continues down the current path US supplied materials and goods are going to become extremely cheap and their consumers will make start to take advantage of those savings. That’s what Bush is counting on. And they have a strong argument for believing that will happen.

The problem is that in the meantime the dollar continues to fall digging the US deeper and deeper into debt. This is the point the media is harping on and then talking about the theoretical possibility of the world market becoming extremely bearish on the dollar plunging the US into massive recession. And yea it could happen. But I don’t think that scenario is possible. The financial well being of the US is too important to the financial well being of the EU, and Japan etc. If the US economy goes to crap they will suffer. They only real choice the EU has is to intervene, sell the EURO and support the dollar.

So both scenarios should work in the favor of Bush’s current dollar policy. If the dollar continues to slide our exports will pick up and reverse the overwhelming growth of our current national debt. Or the G8 will intervene, support the dollar, and in so doing shrink the US national debt by devaluing their currency against the dollar.

The question is when the hell will all of this happens. It’s a good think Bush has a lot of faith because I think that’s what he is operating on. I would like to see the dollar stronger – the black hole that is out national debt is spooky.

I think China's role in all of this is predictable - and as such I assume the FX markets have already taken into account that there is a good chance that China will keep their currency pegged where it is to the dollar to keep the value (or cheapness) their exports the same.

The only change China is likely to make would be in favor of the US economy - China may increase the value of their currency to put a damper on their economy growth since I believe they have increased fears of inflation.

Of course if China where to suddenly make their currency transparent to the FX market who knows what would happen though I read somewhere that most traders speculate that the value of their currency would crash in the same grand fashion as the Argentinean Peso a few years back.

Thanks Toby, that was very enlightening. I think you are right about the dollar's slide will have non US consumer snapping up goods-the stores here pretty reliably reflect the state of the exchange rate. I don't think this contradicts your point about private companies being slow to react to new market conditions in terms of raw materials and supplies as the cost of changing suppliers is often high, but it would be interesting to know what percentage of US exports are ready made goods and what percentage is supplies and how much ready made goods could ramp up.

I'm curious, hilzoy. I know we have a trade deficit. Why do you think it's a problem?

We (former) mathematicians like to look at things by considering what we call the n-case or the limit case. The 0 case is we don't import anything (autarky). That's been a failure for every country that's tried it. The n case is that we import everything and don't export anything. The dollar would fall (who would want to hold it?) and U. S. products would become a better buy.

Think of the Chinese trade policy as a method of subsidizing their exports (and keeping unemployment under control). The only thing we have to worry about is if they stop. If they stop we won't have to worry about the Chinese at all—they'll have more than enough problems of their own to worry about.

Dave: The short answer is, because the current account deficit is financed mostly by debt and/or the sale of our assets. Eventually, a trade deficit will (literally) bankrupt us.

The shorter version of the slightly longer answer is, because long before that happens, this will throw us into a serious economic tailspin. Suppose the value of the dollar does fall, and suppose further that at some point the willingness of Asian central banks to prop up our currency runs out. We will then have to raise interest rates in order to induce people to pay at least for the bonds we need to continue with our (irresponsible, appalling) deficit spending, and this will raise rates across the board in the US. Bad news in any case, but consider three results of a significant hike in interest rates: first, since our debt is largely in short- and medium-term bonds, we will have to roll them over at that higher rate, which increases the amount of money we have to pay on interest to the debt. (Currently at 17% of tax revenues, if memory serves.) Second, the housing market tanks. And since a lot of people have been financing their spending with refis, and failing to save because they're treating their houses as their nest eggs, this would be very bad news. Third, in order to raise our exports anywhere near enough to balance the trade deficit, we'd need to construct new plants and so forth, and a significant hike in interest rates would make financing that construction a lot more costly at the moment we'd need it most, and would therefore interfere with the adjustment and rebalancing process.


Thanks for the interesting comments. What seems to be going on is that foreign countries are lending us money just so we can continue to buy their exports. Doesn't that have to end badly, for someone?

At some point realistic fiscal responsibility has to enter into the equation. There is no clear cut metric than you can apply to an macro economic factor to determine if some critical threshold has been violated.

What Bush has been doing is just a band aid designed to stop the bleeding from the popped tech bubble/ post 9/11 market jitters / war time economy. I think most of those hurdles have been put behind us or have been taken into consideration in terms of market performance. It's time to start looking at how to correct problems like the trade deficit, strength of the dollar or the intra-bank lending rate that still is woefully low (though the Fed has been pretty consistent with the rate hikes). What Bush has forgotten is that the additional tax cuts he continues to extend to all of us isn’t helping the situation and then go ahead and insert typical liberal BS about righting the sinking ship that is our economy, balanced budgets, surpluses, blah, blah, blah because that is my opinion.

Kudlow's take:

Here’s one story you won’t find on tomorrow’s front pages: “The U.S. Budget Deficit Is Shrinking Rapidly.” The headline would be accurate, but the mainstream media is much more interested in talking down this booming economy than telling it like it is.

This week’s Treasury report on the nation’s finances for December shows a year-to-date fiscal 2005 deficit that is already $11 billion less than last year’s. In the first three months of the fiscal year that began last October, cash outlays by the federal government increased by 6.1 percent while tax collections grew by 10.5 percent. When more money comes in than goes out, the deficit shrinks.

I saw that article. It mentions a couple of nice stats:

According to the Washington Post, the Bush budget totals planned for fiscal year 2006 may be essentially unchanged from the totals for fiscal year 2005 (excluding defense and homeland security).


At this pace, the 2005 deficit is on track to drop to $355 billion from $413 billion in fiscal year 2004.

While that is something that should make us feel a little better about things what Kudlow fails to mention (as well as most other budget analysts) is that the money funding the war in Iraq is left out of those figures - so the numbers perhaps improving, are still much farther into the red than those figures would lead you to believe.

Gee Stan. That's great news. If that's a typical quarter the deficit will shrink by $44 billion in 2005. Of course the CBO projects a $75 billion reduction, and I think OMB is even more optimistic. Could it be we're running behind schedule a bit?

Stan: here's Juan Cole's take: "As usual in Bush's Iraq, there are no good options here because the administration's prior bad decisions have poisoned the most promising wells for the future." You might say, but that's his take on elections in Iraq, which are another subject entirely! And then I might say, yes, but the same is true of the article you linked to.

Kudlow is not telling the whole story. The fact is, the deficit and individual income tax receipts have just begun to recover from their lows reached in late 2003 and early 2004. The only "roaring" to be heard has been in spending and, to a lesser extent, those receipts whose tax rates have not been cut. See the full analysis of Kudlow's article at the URL attached to this message ( http://home.att.net/~rdavis2/kudlow3.html ).

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