from Follow the Money

The dollar is a currency you run to, not from

May 4, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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So says Dr. DeLong.   He is right.  The dollar traditionally has been a safe haven in turbulent times.   LTCM didn’t get into trouble being long dollars.   

Treasury bonds are another thing you run to, not from.   LTCM got into trouble in part by  being long the less liquid 29 year Treasury bond rather than the more liquid 30 year bond when everyone ran not just into Treasuries, but the most liquid of Treasuries.

And usually, when the US economy – or for that matter the global economy – slows, US interest rates fall.  That is one reason why nothing all that bad happens to the US economy.   Strong growth pushes up rates, slowing growth.  And weak growth pushes down rates. 

Of course, it doesn’t always work that way.  At least not for other economies with big external deficits than needs lots of financing from the rest of the world.  Ask Iceland.

These traditional maxims are based on a world where the US had a far smaller trade and transfers deficit than it has now.   The US trade and transfers deficit was 7% of US GDP in the fourth quarter.  And all the signs I see suggest it is going to get bigger this year – if the Gulf doesn’t churn up a hurricane that generates payments from European reinsurers, oil stays high, Japanese cars do well and the US consumer doesn’t give out, an 8% deficit in the fourth quarter seems quite possible.   

It is a bit strange to view the dollar-denominated debt of the country with the largest external deficit the industrial world has ever known as a classic safe haven.

The argument that US interest rates will fall as the US economy slumps implicitly assumes that America's foreign friends will continue to finance the US at low rates.  That is what the Fed is banking on, with studies to back their position up.   But it is still a bit.  A big one. 

Remember, the US doesn’t save – so it we want to invest, we have to borrow from abroad.  That is another difference from the past.  Foreign creditors should care more about the risk of dollar depreciation than the risk of domestic inflation – and a US slump might well induce fears of dollar depreciation.

The “hard landing” scenario is a “foreign flight” scenario.   Realistically, it could well be a “consumer burnout” gives way to “foreign flight” scenario, as falling US policy rates trigger foreign flight.

The trigger isn't important.  The key point is that the dollar won’t be viewed as a safe haven.  Cuts in policy rates may not lead other rates to fall, as foreign creditors balk at buying low-yielding dollar-denominated assets in the face of the risk of further dollar depreciation.   And risk models – the kind Goldman uses to make so much money – may be based on correlations that held when the dollar was a currency that you ran to, and don’t hold should the dollar ever be a currency you run from, not a currency you run to.

And if central banks ever stopped propping the dollar up, folks should run.  Americans as well as foreigners.    And maybe into emerging economies rather than into Europe.  Talk about role reversal. 

The total amount of money emerging market central banks spent propping the dollar up in April is going to be stunning.    Korea’s reserves are up $5.6 billion in April.   No more than $3 billion of that comes from the rising value of Korea’s euros and yen.  India’s reserves are way up too.  They increased by $5.6b in the first three weeks of April.   Some of that is valuation, but not all.   Russia added $20b (ok, $19.8b) in April alone.   That is a China like number.  No more than $5b of Russia’s $20b increase came from valuation gains.   And so on.   The Saudis usually track the Russians.   And, well, China’s reserves could rise by $10b in April just from valuation gains.   China presumably has over $200b in non-dollar reserves.   And it also intervened in the foreign exchange market to keep the RMB down.

It doesn’t seem the US Vice-President (and his crowd) like any of the United States’ big current creditors all that much.    China isn’t a friend of freedom.  Saudi Arabia isn’t a friend of freedom.  At least not anymore.  The US is a lot closer to the smaller states in the Gulf.  And Russia’s isn’t either

Jen’s dollar zone will last only so long as central banks are willing to increase their dollar purchases.  The flows that sustain it are decidedly not private.  And lots of the flows also don't come from the United States' closest friends.

Just thought i would point that out. 

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