28 Sep 2010

The Dollar’s Demise?

Economics, Financial Economics No Comments

Robert Wenzel has recently started the EPJ Daily Alerts. I try to check it out everyday; it reassures me to know Wenzel is out there, scouring the internet for new developments. (He’s not paying me to say that, but he’s also not charging me for the subscription.)

In today’s Alert, Wenzel mentioned that the dollar is at a 5-month low. So I decided to check things out with the trusty graphing tools at the St. Louis Fed (which, incidentally, are a lot more powerful than they used to be):

The eclectic von Pepe and I have a running joke where I tell him, “I had to stop looking at these charts before I turned into Nash.” (I.e., if you stare hard enough at something, you will “see” a pattern.)

Even so, my Spidey sense is tingling. In July 2007 I did a forecast for a bank (which later inspired this somewhat-prescient article) in which I realized people like Peter Schiff were totally right in their doomsaying.

Part of what pushed me over the edge was that the current account deficit’s increase (i.e. getting more negative) went hand in hand with a falling dollar. That told me that the people who were saying, “Don’t worry, trade deficits are fine, people love U.S. assets and a current account deficit is just the flip side of a capital account surplus” were fooling themselves.

That type of story made sense in the late 1990s, when the dollar was gaining strength against other currencies even as the current account deficit grew. But from 2002 onward (in the midst of Greenspan’s rate cuts) the dollar started tanking even as the current account deficit grew. So that told me all was not well.

But now flip things around and look at what’s happened in the last few years. To hear Krugman and DeLong tell it, the reason the dollar has gone up so much, is that everyone’s rushing to buy Treasurys.

But if that’s the case, then wouldn’t the dollar’s rise be sharper than the “improvement” in the current account deficit?

Yet the chart shows the opposite. In other words, it looks like the dollar was pulled up by Americans’ spending habits, not because foreigners all of a sudden really wanted to get more US financial assets.

Standard disclaimer: It’s almost bedtime and we probably need to decompose these variables to truly test these hypotheses. But from staring at this graph (and also the plunge in the dollar during the last few months), I think we have yet more evidence that we’re in big doodoo.

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