I am dared to believe the dollar is undervalued

Paul Krugman writing in Economic Policy estimates that at a real dollar depreciation rate of 2% per year the US is headed for a steady-state capital-account position of -15 months’ GDP, and that at a rate of 4% per year is headed for -7 months’ GDP. Yet foreigners–both private and central bank–are not demanding any yield premium on US assets.

This worries him, very much: situations in which large numbers of speculators, investors, and financiers hold irrational expectations are situations that could rapidly move southward overnight should reality intrude into the mind of the capital market.

Link here.  I know full well that in most sensible intertemporal models the U.S. dollar is overvalued and must fall further to set right the trade balance.  But these same intertemporal models don’t explain business cycles or unemployment very well (they do at times, but that’s it), so why should they explain currency values?  Nor do these same macro models command the full loyalty of Krugman and other pessimists in different settings.

I do know that purchasing power parity predicts long swings in exchange rates to some crude extent, and right now I’m dead set against family summer vacation in Europe.  So I will accept this dare and assert that the U.S. dollar is undervalued in world currency markets.


Oh, snap! I can't believe he actually asserted it!

Bold words, Professor Cowen, but can you back them up with a purchase of dollar-long currency options?

(Sorry, been playing too much Alpha Centauri.)

It's no secret that the Euro has been the disproportionate beneficiary (victim) of the global overvaluation of the USD. The same cannot be said of the Asian currencies who continue largely to peg their currencies to ours. So Tyler, you may be right about that European vacation. I would go to Asia before it too becomes unaffordable to Americans.

What I cannot figure out is how and where the inevitable inflation that we are creating through our accumulation of massive internal and foreign debt will play out. Devaluation is always in the interest of foreign debtor nations. "Our currency, your problem," as Mr. Nixon famously said. But will the wave of inflation also be exported? Seems to be happening in China already.

Cue Robin to ask how much you've bet on it....

A good rule of thumb in such matters to be on the contrarian side. Since most people predict further decline, I am inclined to predict a rise over the next year.

PPP holds in the long run. Given that, the US dollar is very much undervalued. I don't really see too much difference between now and, say, 2004, when the dollar went on to recover almost twenty percent on the Euro.

Also, as house prices fall, the lifecycle model would make us believe that cash savings should increase, therefore consumption of foreign goods should decrease, therefore the dollar should improve.

Well, lets go long on the dollar Tyler. Great chance to see if you are correct and make some $.

Somebody actually thinks that a vacation to Europe and Florida are equivalent? Its simply amazing
to see somebody state (almost boastfully) they would rather go to Florida then Europe. Amazing. Maybe
if they put in more TGIF, Strip Malls and franchises the South of France could become as appealing as Florida....
Idiocracy here we are.....

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I should have said economic forces, not market forces. The market could take the dollar lower for a long time, maybe until January 2009?

Is the purchase of US Treasuries by the Central Bank of China a 'rational' act? Aren't they buying them to keep the yuan/dollar pegged, or to limit the rate of dollar depreciation against the yuan. Is China's trade surplus with the EU significantly less than their surplus with the US, so they would have more incentive to keep their products affordable in the US, with less attention to the EU where they may sell significantly less products.

Huh? As a non-economist, I understood little of the discussion above. Can it be written in a way that the average post-graduate degree holder can understand?

I am not sure that there is any validity to saying the dollar is overvalued or undervalued when discussing the currency markets. The markets are very open. My understanding is that the value of the dollar (in floating currencies) is driven by supply and demand. From this, I conclude that, from the day that the dollar was floated, it was neither overvalued nor undervalued.

Of course, there are factors that can affect the price of the dollar. The US government can produce more of them. Other governments or large dollar holders could disgorge a substantial amount of dollars on the market. People can like dollars and be willing to pay more because the US is so awesome. Banks can offer a higher rate of return on dollar savings. And the value of companies priced in dollars can go up.

I am worried that the value of the dollar has declined. I am worried because I believe that it is due to bad economic policies. I do not believe it has anything with the price of the dollar being "wrong". IMHO, the policy of the government should be to make dollars more valuable.

The Euro has been over 1,30 a few times in the past years on spikes but the average annual rate for the Euro/$ has been just over 1,25 in 2004, 2005 & 2006. It is only in 2007 that the Euro has traded consistently above 1,30 so it might be premature for the European decision makers to proclaim Euro land can cope with a real strong Euro. The markets are very selective in what they want to see ignoring for example that Euro land has higher government debt as a percentage of GDP, worse demographic trends, worse problems assimilating immigrants. Add to this certain countries were allowed in by fudging official economic data and nothing happens if member states break agreed limits on max. budget deficit as percentage of GDP and deficit/GDP ratio.

Of course it is also ludicrous to use mostly German economic performance (25 % of the population in the Euro area) to justify the market rate for the Euro. France, Italy and Spain as a block have almost double the population of Germany.

But remember if you are a believer the dollar is clearly undervalued you can take solace in the fact the same “financial gurus† that now think 1,48/1,50 is fair value are by large the same who 5/6 years ago thought the correct value to be 0,85 or going back a little further thought 1:1 Pound/$ was justified.

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