Three links

1. How much do hard-working coworkers make us work harder?

2. Why is the dollar falling?  Call me crazy, but all this talk makes this natural contrarian think it is undervalued.

3. People with low self-esteem don’t like the twists in mystery novels.  I guess it makes them feel stupid.


Not stated was whether there was any correlation between self-esteem and open-mindedness.

Perhaps the high self-esteemers also were more likely to consider a wide range of potential killers, and therefore end up with the happy burst of "Yeah, I knew it wouldn't be the obvious choice!"

The biggest reason to agree with your contrarian viewpoint:

Over the long term, currencies tend to drift towards purchasing power parity. At current rates, prices are far higher in the UK, Euroland or Japan. Ergo, the dollar should rise against those currencies.

As I see it the US Current Account (CA) deficit can be resolved by two different mechanisms (though a combination is not impossible). The first is what I call “radical deflation†. The second is via changing exchange rates. It is my considered opinion that powerful forces in China and more relevantly the US favor the first approach. Let me try to outline each potential adjustment path and consequences that flow from them.
1. The “Fixed† approach – The dollar/RMB peg remains sacrosanct or changes so slowly as to be meaningless (as is currently the case). In this scenario the US raises its savings rate via some combination of policies including higher taxes ($5 gasoline tax, 10% VAT, massive income tax hikes) and higher interest rates. Raising the savings rate enough to eliminate the need foreign capital drastically reduces domestic spending.
The reduction in spending both reduces imports directly (fewer Mercedes and 50† plasma TVs) and releases resources for export. Calculations have shown that a 17% fall in GDP is required to eliminate the CA deficit via this mechanism. See Why America is switching to a weak dollar policy. A 17% fall in GDP is what most people would describe as a depression. I have used the phrase “radical deflation† for this outcome.
How would the Chinese benefit from this tact? A 17% fall in GDP via tax hikes and higher interest rates would cause the CPI to decline (as it did after 1929). Chinese holdings of dollar assets would increase in value. Of course, much of America could be purchased for a song during the new “Great Depression†.
This is the adjustment path that the advocates of fixed exchange rates advocate. I would include Mundell, McKinnon, Mankiw, and perhaps Stiglitz in this category. It is also the modern version of how trade imbalances were resolved under the gold standard (which Mundell advocates). Under the gold standard specie flowed out of a country with a trade deficit reducing the internal money supply and inducing economic contraction. Eventually the deflation reduced imports and expanded exports to the point where the trade deficit was eliminated. Of course, the consequences for employment and economic stability were harrowing.
2. The “Floating† approach – Of course, this really means a large devaluation in the dollar. How much? Perhaps 50%, perhaps more. Take a look at Trade-Weighted Exchange Value of U.S. Dollar for how much the dollar fell after the Plaza/Louve accords. Note that this devaluation eliminated a (roughly) 3% CA deficit. The current CA deficit is more than twice as large.
Per se, devaluing the dollar can not close the CA deficit. However, related economic shifts will. If foreigners stop funding the US CA deficit, as the dollar falls (why hold a declining asset), then US 10 year treasury yields will spike. This will reduce both housing and equity values and thereby raise savings. However, assume for a moment that doesn’t happen. As the dollar fall, demand for exports will rise and import prices will escalate. Both effects will tend to raise the CPI. Stated differently, total demand for US production (and labor) will exceed resource availability raising prices.
The Fed will have to counter this effect by raising US interest rates to cool domestic demand (increasing savings) so that resources can be released in export production.
What does this approach mean to the Chinese? Their holdings of dollar assets loose value two ways. First, their dollar assets are now worth materially fewer RMB. They suffer capital losses on their dollar portfolio. Second, US prices tend to increase (Fed policy could strictly limit this) making each Chinese owned dollar asset worth less. Of course, with export demand offsetting the decline in domestic demand there isn’t a US depression. No opportunity to buy America on the cheap.
What does this approach mean for the US? Perhaps higher inflation, although not much based on the experience of the late 1980s. Certainly no repeat of the 1930s. However, if the Chinese are forced to accept losses on their dollar asset portfolio they won’t be happy. They might decide to cut off the investment banker gravy train. The Goldman bonus pool might take a hit.
The choice here should be obvious. The sad part is how many people regard fixed exchange rates as sacred and favor deflation as an adjustment mechanism.
It should be clear that China and the United States are not solely responsible for global/US imbalances. The OPEC states appear to currently enjoy trade/CA surpluses larger than China. Only a fraction of the US trade deficit is with China. Other Asian (and a few non-Asian) nations have large trade surpluses as well. The US dollar is overvalued against many currencies, not just the RMB.
However, in one very important respect China is central to the resolving the US CA deficit. Apparently, many Asian nations won’t allow their currencies to rise against the dollar until the RMB revalues. That makes breaking the dollar/RMB peg crucial.

The USD is doing very well.

Investing in currency, if you're a central bank, you think of the currency much the same way you or I would think about buying stocks or bonds to put into our portfolio.

Would you buy stock in a company that is doing poorly? Out of whack P/E? Over-leveraged?

No, you would not.

Likewise, countries have made the USD the global reserve precisely because there's no better place to invest.

In 2004 there was supposed to be major rebalancing throughout the world, with many, many countries shifting their currency balances to carry much more Euros. Currencies are hard to track, but long story short, no such rebalancing ever took place.

The EU is trying to sell the world their stock, i.e. the Euro, in order to bolster the United States of Europe, and hopefully eat away at the dollar as the global reserve. Thus, all of the same folks that constantly predict America's demise because we're no longer the king of cheap manufacturing, are the same people saying that a "weak" dollar will be our downfall.

Long story short, to unwind the global currency questions, just look at the underlying economies, and not just only, but also their basic systems. Perhaps the Frasier Inst's economic index coupled with a country's current numbers i.e. unemployment, interest rates, inflation, etc.

To finish the analogy, investing in the EU right now, would be akin to investing big in Ford or Dana.

BTW, the bottom line (writing this from Chennai, India) is
that given the random walk finding, it does not matter whether
the dollar is "undervalued" or "overvalued." Short run forex
movements will have nothing to do with that (or very little)
and anyone buying or selling currency on that is simply
putting deluding themselves regarding a nice way to throw
darts at a moving target.

On the topic of peer pressure making people work harder/faster, my experience in the workplace tends to agree with the general conclusion that the effect is real, but I think there are many more than just two explanations for this effect. Now, if all these factors could just be optimised to maximise this peer pressure effect, it could be economical to pay more to hire an especially fast worker and to place them in a central location so as to boost the productivity of the entire workforce! Of course, once this motive becomes known, it's game over.

Barkely Rosser,

“No, there is nobody in the US pushing for fixed rates with the yuan/rmb, powerful or not†
Mundell China should keep currency peg Of course, he also favors the gold standard, the ultimate in fixed exchange rates.
Mckinnon McKinnon believes in China's currency peg. and Why China Should Keep its Exchange Rate Pegged to the Dollar
Mankiw Hume vs Schumer and Graham
Cooper Living with Global Imbalances

“They are keeping their currency down to try to absorb those hundreds of millions pouring off the countryside into the cities into jobs so they do not riot and overthrow the undemocratic government†

This may be true, but China does have alternatives. Brad Setser makes this point better than I can.

And I remain unimpressed with this argument

"Given the sheer size of its surplus labor force, China has no choice but to expand the export of its labor services to create jobs."
no choice? really. those workers could not be employed producing goods to sell to a chinese consumption boom, or building up China's infrastructure. and how exactly did China ever manage from 95-01, when it had even more surplus agricultural labor, was cutting employment in SOEs more aggressively and tied its currency to an appreciating dollar -- so its trade surplus was basically constant.
I accept that transitioning off China's current model poses real challenges, but saying it has no choice is a bit of an exaggeration.
“Russia and OPEC powers probably more important than China†

“OPEC states appear to currently enjoy trade/CA surpluses larger than China† (my comment above)

“The inflation would occur because their goods coming in would be expensive because their currency can buy stuff here so easily†

Dollar devaluation would impose large capital losses, more than offsetting purchasing power gains, at least in the short term. Long term the reverse is presumably true.


The only nearly sure way to make money in forex
markets is to be an arbitrageur, which means having
lots of money instantly available and simultaneously
watching lots of markets very closely. Investment
banks hire young people who burn out quickly to do
this for them. Hope you are not one of them.

That said, there is evidence for some trends,
including the famous 15% reversion to PPP. On that
last one, the US may be undervalued relative to the
Brit pound (and the Swiss franc), but is not so clearly
so vis a vis the euro, and probably overvalued relative
to the yen and the yuan/rmb.

Peter Schaeffer,

I probably was overly grouchy having had to deal with
a falling dollar in practice against both the euro and
the rupee in the last week. I should have kept my
remark about who supports fixed rates to policymakers
and politicians. Of them in the US, I know of none that
do, despite the US Treasury not certifying manipulation
by the Chinese.

That said (and I note that none of your links work),
you overstate things regarding the folks you mentioned.
Over on econbrowser you also mentioned Stiglitz and Mankiw,
who have been powerful, but neither supports either fixed
rates in general nor a fixed dollar/rmb peg that I am aware
of. They do both seem to want less volatility and have
mumbled about a new Brettons Wood.

Mundell's view on the China/US peg is just an extension
of his general and longstanding support for universal
fixed rates, a point you are aware of. MacKinnon, who
is an advocate of gradualism in China, is the one where
you may have a point in terms of talking about China.

I am not opposed to your general view, and I also follow
setser and chinn. There are alternatives for the Chinese,
and indeed the yuan/rmb is gradually appreciating relative
to the dollar, though clearly they see an undervalued
yuan/rmb as an easy way out.

However, your remarks about deflation in the US making
it harder for the Chinese to "by America on the cheap"
remain just as incoherent as they did originally.
And why would forex capital losses for the Chinese due
to a devaluation of the dollar make it harder for them
to buy US-dollar denominated assets? More incoherence.

To others regarding the rest of Asia. It is now clear
that the Thais put their capital controls in to stop the
appreciation of the baht against the dollar, which, of
course, did not work. The Koreans are also unhappy about
this, and I have just read the Indians are also, although
I saw nothing about this latter while I was in India.

Comments for this post are closed