An interesting debate involving my FT colleague Willem Buiter, who thinks that a falling dollar could become very bad news for the US economy, and Paul Krugman and Brad DeLong, who are much more relaxed. Since all three know their international macro, I speculate that the difference turns not on economic insight but on a European as against an American perception of the issue. A currency depreciation as big as the one the dollar has already experienced–to say nothing of the prospect of a further drop–would be a big inflationary problem for a small, open economy like Britain (which still has a currency of its own). The effect is muted for the US, because its economy is bigger, less open (not because of import restrictions, but by virtue of its size), and because exporters selling to America are more inclined to price to market. Come to think of it, that is just three different ways of saying, "its economy is bigger".

Willem address the point explicitly:

With US long-term real interest rates now set largely by world markets rather than by domestic monetary and fiscal policy,  the US policy makers  will have to get used to operating in a setting that is quite unlike the closed economy paradigm that they grew up with, and more like like a small open economy.  On the financial side, it has, effectively, already happened.

Paul says:

One way [to argue that the results of a dollar fall might be very bad] is to argue that the Fed will have to raise interest rates more than is necessary to stabilize employment. The usual reason given is that the falling dollar will be inflationary, so the Fed will have to support the dollar with higher interest rates to ward off this inflation. OK, this could be right, but I have a hard time making the numbers look big enough to get worried about: imports are only 16 percent of GDP, and exchange rates are much less than fully passed through into import prices. The big dollar fall from 1985 to 1988 wasn’t notably inflationary.

Paul goes on:

Another argument I used to make was that a dollar plunge would pop the housing bubble, setting in motion a rapid fall in domestic demand that would outpace any rise in exports. But the bubble popped all on its own, so I don’t think this is still valid.

Finally, there’s a fairly subtle argument about term structure and timing.
You see, the Fed only controls short-term interest rates, while investment spending depends on long-term rates. Meanwhile, the effects of a weak dollar on exports take a while, maybe as much as two years, to take full effect.

So there’s a story that runs something like this: a plunging dollar will eventually be very expansionary, and will force the Fed to raise rates to cool off the economy — not now, but a year or two from now. But the expectation of this future rise in short-term rates will push up long-term rates now, causing a recession even if the Fed does nothing. This story depends on the effect of interest rates on demand working faster than the effect of the exchange rate on exports.

I guess this could work. But it’s a fairly tricky story, and a lot subtler than the alarm I’ve been hearing.

The American economy–to my British eyes–does seem astoundingly immune to the inflationary implications of currency depreciation. By itself, this would incline me to Paul’s and Brad’s view of the matter. But now add oil prices into the mix, and the risk that they might yet go higher. If nothing else, this adds another complication to the Fed’s calculations. And the popping of the housing bubble is not an all or nothing thing, as Paul seems to say. Higher interest rates could turn the slump in the housing market into a rout; debtors are screaming already. However you look at it, this is an environment in which short-term interest rates are being asked to shoulder a much larger burden than they can carry. I think it would be better if an abrupt flight from the dollar stayed in the realm of thought-experiment. 

November 21st, 2007 in Uncategorised | Permalink