Dollar decline: optimism vs. pessimism?

Read Brad DeLong (the best econ post this week; for better or worse, no one gets impeached).  My view is simple: I don’t much trust any very specific macro model.  So I look at current market prices and I ask two questions.  First, does the country in question have relatively sound fundamentals, relative to other parts of the world?  Despite the erosion in the quality of governance in the U.S., I still answer yes.  Second, I try to develop a crude but intuitive "theory" of what the market hasn’t taken into account.  I don’t have a strong guess here but the Setser-Krugman pessimistic view seems well enough known that it doesn’t fit this bill.  That gives me a second reason not to be a pessimist.

More specifically, I am not what Brad calls an "international finance economist":

International finance economists, by contrast, look at the asset markets. A 40% decline in the dollar over four years is a decline at the rate of 10% per year. Once financial markets convince themselves that such a decline is coming and that they need to be compensated for it, that ought to drive a 400 basis point wedge between U.S. and foreign long-bond expected returns.

I would be surprised if a dollar decline led to such consistently high interest rates in anticipation.  Uncovered interest parity is an unreliable relationship and often the relevant variables behave more like random walks, whether or not they should according to theory.  Also read this Economist article on why interest rates may not skyrocket if the dollar dives; links to specific papers are at the bottom of the article.

Addendum: I don’t think I have had any influence on his specific subsequent views, but I am proud to have had Stephen Jen as an undergraduate in the first class I ever taught at UC Irvine.


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