It is ironic that the dollar has strengthened rather than weakened over the last year.

· The sub-prime mortgage crisis originated in the United States;

· The crisis has severely undermined the credibility of American financial institutions – both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on)

· The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro… that day is not today.

The most noteworthy flows into the dollar and into US treasury securities have for some years been coming in the form of purchases by foreign central banks. The People’s Bank of China reached $ 2 trillion in international reserves at the end of 2008 (actually 1.95 trillion), which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly.     China’s leaders are beginning to worry that the debt is growing too large, and President Obama recently had to reassure them about the safety of US Treasury securities.  The American public is increasingly being made aware that the United States has grown dependent on the Chinese for its funding, that our interest rates will go up if they stop buying our treasury bills.  

     There is another irony, however. Even while the US has grown increasingly dependent on holdings of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.   Be careful what you wish for !

(The accompanying cartoon captures the idea… except that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”   And in fact the danger is that the dragon will at our request stop flooding us with liquidity.)

[Source: KAL’s cartoon From The Economist print edition - Aug 9th 2007 - Illustration by Kevin Kallaugher

http://media.economist.com/images/20070811/D3207WW0.jpg]

     The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded, allowing the RMB to appreciate against the dollar. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post in two days.

     My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

 On the one hand, I have argued:

(i) that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations

(ii) that it is dangerous to ignore the flip-side implications for funding of US deficits, and

(iii) that it is unwise to use language such as “unfair manipulation” or “violation of international rules.”

On the other hand, I have argued that an appreciation was both

(i) in the interest of China, for a number of reasons, and

(ii) in the interest of the world, to help address the global imbalances problem.

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it would be more logical to ask for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

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This was to be expected.  It is an unseemly tooting of ones’ own horn, but –

“The traditional pattern is most clear with the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”

Although the phrase “carry trade” became widely popular in the context of currency speculation, where scholars know it as the “forward discount bias,” its etymological root is in commodity speculation.     Broadly speaking, the same phenomenon is observable in housing, equities, commercial bonds, and emerging markets:   when money is easy and nobody is worried about risk (2002-2005), the search for yield sends the excess liquidity surging out of the low-interest currencies, and into all other assets.    When the process reverses, investors pull out of the risky assets and retreat back to the safe haven of the low-interest-rate currencies.   Over the last six months, the reversal of this broadly-defined carry trade hit equities and bonds first, and then commodities (having hit housing earlier, of course).   This month it is finally hitting the high-interest-rate currencies.

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal.  Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch.   Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I.  Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture.  But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand:   By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army).  The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to do.
 
Among politicians, pundits, and the public, many currently are trying to blame speculators for the recent boom in oil and other mineral and agricultural products.    Are the soaring prices their fault?

Sure, speculators are important in the commodities markets, more so than they used to be.  The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price.    That is speculation.  But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases.   Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode.   Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers).  In other words they may have delayed or moderated the price increases, rather than initiating or adding to them.  One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them.   Clearly speculators are the conspicuous scapegoat every time commodity prices go high.  But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices.   First, there is the “bearer of bad tidings” like Cal in East of Eden.  The news that, in the future, increased demand will drive prices up is delivered by the speculator.  Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand.  Without him, the subsequent price rise would be even greater, because supply would be less.    Most economists agree that speculators did not play this role in the commodity boom that started earlier this decade:  as already mentioned speculation, if anything, lagged behind the spot price.   (An exception, however, is Alan Greenspan, who told Krishna Guha of the Financial Times that speculators played precisely this role, moving forward and smoothing out what would have otherwise been an even sharper peak in prices.)

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price.   This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends.  Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium.  The markets don’t always get it right.   Examples of previous speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry.    As noted, there is little evidence that destabilizing speculation has played a role in the 2001-2008 run-up of commodity prices.    So far, that is.   Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase.    The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively:  rising US real interest rates, 1980-84;  easy money and rapid growth in Japan, 1987-89;  US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).  

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets:  easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc., etc.  

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.] 

 
The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser).   It makes sense.  The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.  The economic dynamism — most striking in Dubai –  is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating.  Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers.   An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies.   This would be an improvement.   Kuwait, for example, made this switch a year ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be.    Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be.   A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks.  But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. 

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor.  But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg.   I have laid out the case elsewhere (including also for the case of Iraq).  I call the proposal PEP, for Peg the Export Price.   I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

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My friend Barry Eichengreen, together with Marc Flandreau, has written a column in today’s Financial Times, that appears under the headline “Why the euro is unlikely to eclipse the dollar.” The body of the article is a claim that network externalities and tipping points are not important, or perhaps that they once were but no longer are.

The first two steps of their argument are:
(1) a multiple-currency system is the historical norm. The dollar-denominated system that we have experienced for more than 60 years is an aberration, so network externalities (aren’t) important.
(2) The dollar surpassed the pound in the 1924-25, not in 1948, so lags and tipping phenomena are not important.

Regarding (1), I have always thought that Barry has a good point that a multiple-currency system has one advantage, that it gives the lead currency some competition, which discourages it from abusing its position by excessive deficits, money creation, inflation and depreciation. But I disagree that network externalities are not also important: there will always be an advantage to having a lead currency internationally, just as there is an advantage to having a single money within each country.

Regarding (2), I have no problem dating the pound’s loss of supremacy from the 1920s, if that’s what the eminent economic historians say. But I don’t see how this affects any of the arguments. For one thing, the US surpassed the UK in economic size in 1872, and in exports in 1915. So there is still a lag of between 10 and 53 years.

More importantly, these propositions have no bearing on the central claim that Menzie Chinn and I have made: based on our statistically estimated effects of economic fundamentals, such as the size of euroland — which has recently passed the US economy — the euro now has the potential to rival or even displace the dollar as lead currency. We think we have also found statistical evidence of inertia and non-linearity, which imply a tipping point. But this doesn’t really matter. The scenario that we most emphasize leaves the dollar with an estimated share of central bank reserves only a little less than that of the euro even in the long run. Regardless what one believes about how fast it will occur or how complete the de-throning will be, our claim that the euro will challenge the dollar stands.

My post last week suggested that the euro may overtake the US dollar as premier international currency. One might ask why this would matter. Some of the reasons it matters are economic: we would lose the “exorbitant privilege” of being able to finance our international deficits easily. But there are also possible geopolitical implications.

In the past, US deficits have been manageable because our allies have been willing to pay a financial price to support American global leadership;  they correctly have seen it to be in their interests.   In the 1960s, Germany was willing to offset the expenses of stationing U.S. troops on bases there so as to save us from a balance of payments deficit.   The U.S. military has long been charged less to station troops in high-rent Japan than if they had been based at home. Repeatedly the Bank of Japan, among other central banks, has been willing to buy dollars to prevent the U.S. currency from depreciating (late 1960s, early 1970s, late 1980s).   In 1991, Saudi Arabia, Kuwait, and a number of other countries were willing to pay for the financial cost of the war against Iraq, thus briefly wiping out the U.S. current account deficit.

Unfortunately, since 2001, during the same period that the US twin deficits have re-emerged, we have also lost popular sympathy and political support in much of the rest of the world. Now the hegemon has lost its claim to legitimacy in the eyes of many.  In sharp contrast to international attitudes at the dawn of the century, opinion surveys report that the U.S. is now viewed unfavorably in most countries.    Next time the US asks other central banks to bail out the dollar, will they be as willing to do so as Europe was in the 1960s, or as Japan was in the late 1980s after the Louvre Agreement?  I fear not. 

The decline in the status of the pound during the course of the first half of the 20^th century was part of a larger pattern whereby the United Kingdom lost its economic pre-eminence, colonies, military power, and other trappings of international hegemony.   As some wonder whether the United States might now have embarked on a path of “imperial over-reach,” following the British Empire down a road of widening budget deficits and overly ambitious military adventures in the Muslim world, the fate of the pound is perhaps a useful caution.   The Suez crisis of 1956 is frequently recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs.  But the important role played by a simultaneous run on the pound, and President Eisenhower’s decision not to help the beleaguered currency through IMF support unless the British withdrew its troops from Egypt, should also be remembered.