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Tyler Cowen take note - dollar pessimism may no longer be fully “priced” in

January 3, 2006

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Tyler Cowen has argued that big shocks come when markets are surprised, and, right now, no one would be surprised by a dollar decline.  People like me (and others with a wee bit higher profile) have already talked the issue to death. 

The markets have had lots of time to mull over the risks associated with a rising US current account deficit, since worries about the dollar clearly have been around for a while.  Warren Buffet started to worry in 2002.  But the dollar was far stronger then than now.   Today it sure seems like the markets have mulled over the possibility that the big US current account deficit might drive the dollar down (from its current level) or US rates up, and then dismissed the possibility.    Probably because in 2005 those who bet on a set of sharp market moves that would help to correct the US external deficit generally lost money. 

Right now, I would say the conventional wisdom is that the US can finance a current account deficit of close to $1 trillion dollars at current or even slightly lower interest rates.   Sort of like the conventional wisdom that a housing slowdown won't have much of an impact on the economy (see Floyd Norris, hat tip, Barry Ritholz).

PIMCO sure seems to be betting that a US current account deficit that may approach $1 trillion won't stand in the way of lower US long-term rates.  And I would hardly characterize PIMCO as the epicenter of complacency about the US external deficit.  Rather I would characterize PIMCO as a firm that thinks it underestimated the forces keeping US bond yields low for the past few years.

Why are the markets so confident that the US can finance its large deficit?  Dark matter?  I doubt it.  Dark matter doesn't generate the inflows needed to finance ongoing deficits.  I think the market's confidence comes from the fact, noted by Stephen Roach, that over the last four quarters (q4 04 - q3 05, there is not yet data on q4 05) investors have bought over $1 trillion in US stocks and bonds (but mostly bonds).  That is more than enough to finance the slightly under $800 billion current account deficit than the US ran over the last four quarters. Recent monthly inflows have been even stronger -- think a $1.2 trillion annual pace.  So why worry?  Particularly if worrying means losing money on the carry ...

There does seem to be a bit of complacency now.  Even among some of the worriers.

Adam Posen is not as concerned about the US current account deficit as the rest of the IIE.  He argues that the US shouldn't take preemptive action to reduce the United States need for external financing (unlike say Bill Cline).  Rather, the world needs to prepare for the adjustment that will come at some point in the future.  But his recommendations for greater preparedness seemed a bit thin.   More bank capital, more cross-border mergers and more inflation targeting hardly seem like a robust response to unprecedented US deficits - though I certainly second the recommendation for a big equity cushion in the financial sector   Ken Rogoff - he of the big future dollar decline - did not put global imbalances at the top of his list of 2006 concerns.   I guess he did not want to be accused of crying wolf. 

At least Martin Wolf still frets.  Stephen Roach too.

One difference between Stephen Roach and me (apart from the obvious stature and salary gap between a blogger and the chief economist of a major investment bank): for all the froth in Middle Eastern equity markets and real estate development in Dubai and Doha, I still think the defining characteristic of the last oil shock is that most of the oil windfall has been saved, not spent.  And by saved, I mean used to build up external assets, not invested in local equities or local real estate.  

Like the folks at Breaking Views, I think Saudi Arabia and others will  spend a bit more -- and thus save a bit less --  this year.   They won't spend as much as I think they should, but the trend is to spend more.  And if oil stays where it is now, that means that the oil superpowers' spending will rise faster than their revenue for the first time in several years.  When the oil superpowers' spend, they tend not to buy American - unlike when they save.  I agree with Breaking Views here too:

That's because the dollar is held up in part by the Saudi cash that finances the huge U.S. trade deficit. While the Saudis aren't as enthusiastic as Asian countries about buying U.S. bonds, money is fungible. So when Saudi Arabia uses its money to buy non-U.S. debt, it displaces other buyers, who turn to the greenback.

But now that the Saudis are buying more goods, the U.S. is likely to lose out. True, the U.S. could theoretically compensate for lost financial support by increased exports. But in practice, goods are less fungible. And the Saudis don't much like buying from the U.S. That is one reason they are willing to buy the Eurofighter, which has lost out to its U.S. competitor in all other export contests. What's more, U.S. export industries are much weaker than their European counterparts. That's why the EU ran a $10 billion trade surplus with Middle Eastern oil-exporting countries in the first nine months of 2005, while the US ran a $28 billion deficit.

The dollar hasn't yet been hurt by the U.S. position as the world's largest oil importer. But the transformation of petrodollars into European exports could change that.

I doubt whether the oil states' future appetite for dollars will match their current appetite for dollars, let alone keep rising.  That leads me to worry about the sustainability of $1.2 trillion a year in capital inflows into US bonds and US equities.  I suspect the oil states combine to account for an even larger share of current demand for US assets than China.  And China added something like $250 billion to its reserves over the last four quarters ... 

What's new.  I always worry.  I just now worry about a (somewhat) new and evolving set of things.  Saudi Arabia and Russia, not just China.

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