Is the United States headed for double bubble trouble?

Richard Baldwin

As the dollar has started to slide, the question is: how far, how fast? This column, which is based on Paul Krugman’s recent Economic Policy article suggests the answers are: pretty far and pretty fast.

In the minds of most mainstream international economists, there is never much doubt that the dollar must eventually decline significantly.1 A trade deficit this big cannot persist indefinitely. Many analysts hope that the necessary real depreciation of the dollar might be gradual. After all, isn’t the avoidance of such jumps one of the reasons we abandoned the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar?

Here is the basic idea underlying dollar ‘plunge scenarios.’ Foreign investors have long demonstrated an increased appetite for US assets, moving a greater share of their portfolios into dollars and thus generating large capital flow into the US. But the capital flows needed to maintain an increased dollar share are much smaller than those needed to achieve it. Thus, when investors reach their desired holdings, there will be a drop off in capital flows into the United States, leading to an abrupt decline in both the current account deficit and the value of the dollar.

Standard asset-price logic, however, argues against this sort of anticipated sudden depreciation. Investors should see it coming, and this will dampen their shift into dollars. Under the ‘gradual scenario’, the adjustment process is smoothed as dollar assets become more attractive while the greenback drops towards its sustainable level.

The asset-pricing logic is impeccable. The only reason to predict a sudden dollar plunge is if we believe today's capital flows are driven by investor myopia. That the markets are due for what Krugman calls a 'Wile E. Coyote' moment – a reference to the Warner Brothers’ cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn’t start falling until he looks down and realizes he’s left solid ground. Up until this 'Wile E. Coyote' moment, his belief that he’s on solid ground prevents him from falling. For investors in dollars, the 'Wile E. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path.2

What constitutes a feasible adjustment path? The key criterion is that the dollar must fall quickly enough to avoid US external debt reaching an unsustainable level. A simple model of the relationship between the path of the exchange rate and the path of external debt can assist in assessing the likelihood that investors are naively chasing the Road Runner off the cliff. Glossing over many details, a 'generic' portfolio balance model of the exchange rate lets us evaluate investor expectations. See Krugman (2007) for a mathematical exposition.

In this simple model, the real exchange rate is a function of external debt and expected appreciation. External debt affects the portfolio balance – a larger net external debt requires foreigners to hold a larger share of US assets or Americans to hold a smaller share of foreign assets, so the dollar must be lower. Expected appreciation affects the portfolio composition – investors prefer a currency that is expected to appreciate in value.

The dynamic of debt accumulation, the other variable of interest, is driven by the exchange rate and the debt level. Since the US tends to hold real assets abroad while its liabilities are denominated in dollars, a real depreciation of the dollar raises the value of US external assets without increasing its liabilities. So dollar depreciation reduces net external debt. The debt level affects its own rate of change in two ways. On one side, higher net debt reduces net investment income. On the other side, the debt-GDP ratio tends to fall, other things equal, due to GDP growth with the size of this effect depending on the initial ratio. Which of the two effects dominates depends on whether the marginal rate of return on foreign debt is above or below the rate of GDP growth; this is not critical to the Krugman story.

Given these standard asset-markets dynamics – and assuming that investors are rational, and that the US external debt is below its long-run equilibrium level – the value of the dollar is held down by expectations of future decline. Forward-looking behaviour rules out a sudden plunge.

But are investors forward-looking? If we believe that there are limits to how high the debt-GDP ratio may realistically rise, then the debt level (and exchange rate) must converge to the long-run equilibrium rapidly enough to avoid exceeding that limit. US net external debt is about 20% of GDP. This ratio will continue to rise so long as the United States runs a large current account deficit. Its rate of change depends on the rate of real depreciation along the assumed equilibrium path – faster convergence implies a lower long-run net external debt.

By how much must the real dollar fall to reach long-run equilibrium? In principle, this is endogenous to the steady-state debt level. A reasonable lower bound on the necessary real depreciation is the decline that is sufficient to bring the US balance of payments on goods and services to zero. Obstfeld and Rogoff (2005) estimate that a real depreciation of around 35% would be required. This is unlikely to be a serious overestimate and certainly might be a serious underestimate.

Given the current debt level and the depreciation required, consider whether there is any rate of convergence that is consistent with both present market expectations and plausible long-run net external debt levels. A 5% convergence rate implies an initial rate of depreciation of 1.75% per year – 0.05 times the long-run depreciation of 35%. This results in an eventual net debt-GDP ratio of 118%, which would generally be considered excessive. A 10% rate of convergence implies an initial 3.5% real rate of depreciation and an eventual debt-GDP ratio of 58%, which would be high by historical standards but perhaps plausible given financial globalisation.

What all this means is that a realistic long-run adjustment path requires real depreciation at more than 2% annually, perhaps as high as 4%. Those are plausible rates – provided that investors are being compensated for the future depreciation by higher real returns on dollar investments. They are not. That’s the catch.

As of April 2007, there was essentially no real interest rate differential between the dollar and euro, and only a 0.9% real differential against the yen. As interest rates dropped worldwide in reaction to the Subprime mess, the gaps will not change much and may even move in the wrong direction. Future real depreciation of 2-4% annually implies that foreign investors are buying US bonds offering low or even negative real rates of return. This strongly suggests investor myopia. If markets are not taking the dollar’s future decline into account, then the world economy is not on a smooth adjustment path. There’s a reasonable case that markets are headed for a Wile E. Coyote moment.

Moreover, the plunge may be larger than suggested thus far. The 35% depreciation target is a conservative estimate. Indeed, the significant secular downward trend in the real dollar – the fact that since 1975 the real dollar associated with any given level of trade deficit seems to have declined –suggests that the dollar has even further to fall.3

Darkish reasoning: how the Coyote can hover

While mainstream thinking asserts that that the US’ big trade gap suggests that the dollar must fall, the dollar itself seemed impervious to such suggestions for years. The strong dollar lasted so long that economists started inventing logics to challenge the mainstream thinking. Four novel arguments are especially noteworthy as they posit structural reasons for why the US current account deficit, and hence the strong dollar, may be more sustainable than previously thought. They are: 1) a global savings glut, 2) privileged rates of return enjoyed by US investors, 3) a ‘Bretton Woods II’ regime, and 4) ‘dark matter’ in trade flow statistics. Let’s address each in turn.

First, many economists, including Federal Reserve Chairman Ben Bernanke (2005), have argued that there is a global savings glut that helps to explain the US current account deficit. While high savings abroad could make a large, prolonged deficit economically sensible, the net indebtedness of the United States must eventually stabilise, necessitating an inevitable real decline in the dollar. If investors anticipate this, then there ought to be a real interest differential between the United States and other countries to compensate them for the eventual real depreciation. There is not.

A second objection might rely on the fact that US investors earn substantially higher rates of return abroad than foreign investors in the United States. If this return differential is real and permanent, then it reflects what Gourinchas and Rey (2005) call – following De Gaulle’s oratorical flourish – an ‘exorbitant privilege.’ But such a privilege is easily incorporated into the thought experiment above. First, it might cause GDP growth to exceed the marginal rate of return on foreign debt, dampening the impact of debt build-up on the adjusted current account. Second, it would modify the estimate of the debt-GDP ratio’s initial rate of change, as the rate of debt accumulation would be further below the deficit on goods and services. Nonetheless, investor expectations remain far from a feasible path. The third novel argument, put forth by Dooley, Folkerts-Landau and Garber (2003), says the international monetary order has entered a ‘Bretton Woods II’ era, in which many central banks, mostly Asian, buy dollars to maintain nearly fixed exchange rates. Thus, despite a low rate of return, dollars will flow into the United States so long as central banks believe they need dollar assets. However, if this bank activity ran contrary to private expectations of real depreciation, we would see private capital outflows at least partly offsetting official capital inflows. But there is significant private inflow, so Bretton Woods II cannot explain the puzzling fact that private investors seem happy to buy dollar assets, despite a very modest real return differential that is overwhelmed by reasonable estimates of the rate at which the dollar must fall.

Finally, Hausmann and Sturzenegger (2007) explain the sustainability of substantial international imbalances with ‘dark matter.’ It’s all down to Mark Twain’s third-type of lie – statistics. Official statistics, the story goes, drastically understate the assets US investors hold overseas by omitting US-based multinationals' exports of hidden assets such as expertise and reputation. However, the puzzling combination of a roughly zero US investment income balance and a negative US net investment position seems to reflect low returns on foreign investment in the United States rather than high returns abroad. This implies that the ‘dark matter’ is foreign firms bringing bad reputations to US markets, which seems unlikely. Moreover, dark matter could only alleviate the need for dollar depreciation if it were rapidly increasing, as its level does not counterbalance the large current account deficit. While it is easy to imagine that many US foreign assets are undercounted, it is much more difficult to argue that such ‘dark matter’ is growing.

Therefore we still have reason to believe that a Wile E. Coyote moment is in the offing. Though it's always dangerous to second-guess markets, the data do seem to suggest myopia, and none of the various explanations of the US current account deficit advanced in recent years ease the difficulty of reconciling the willingness of investors to hold dollar assets enjoying only a tiny real interest differential with the size of the apparently inevitable dollar decline.

In February 2007, Krugman wrote that we seem due for a discrete drop in the dollar. That is looking pretty good at the moment. How much the fall will hurt depends on other things. He wrote in February that a dollar plunge is potentially frightening if it is coupled with a collapse of the housing bubble, but it is unlikely to be disastrous. In the medium-run, a contraction exacerbated by dollar depreciation will be offset by greater net exports. Still, a dollar plunge, by heading off what might otherwise be a substantial fall in long-term interest rates, may extend and deepen a housing-induced slump, as well as reduce the Fed’s leverage over the economy. That would be ‘double bubble trouble’ and it probably won’t be much fun.

POSTSCRIPT ADDED 9 November 2007

Flashback to 1985: Krugman’s view on the dollar

Rummaging around the web last night I came across a Paul Krugman paper on the how far and how fast the dollar needs to fall. What’s noteworthy is the date.

Paul wrote it in August 1985 for the Jackson Hole conference when the US trade deficit seemed huge and the dollar had just started its 3-year slide. The 1985 abstract could be the abstract for his February 2007 article on the same subject.

This paper presents evidence strongly suggesting that the current strength of the dollar reflects myopic behavior by international investors; that is, that part of the dollar's strength can be viewed as a speculative bubble. At some point this bubble will burst, leading to a sharp fall in the dollar's value. The essential argument is that given the modest real interest differentials between the U.S. and its trading partners, the dollar’s strength amounts to an implicit forecast on the part of the market that with high probability the dollar will remain very strong for an extended period. The paper shows that such sustained dollar strength would lead the U.S. to Latin American levels of debt relative to GNP, which is presumably not feasible. Allowing for the possibility that something will be done to bring the dollar down before this happens actually reinforces the argument that the current value of the dollar is unreasonable.

Of course, Paul has become a much better writer since then, so the “bubble will burst, leading to a sharp fall in the dollar's value” is now the “Wiley E. Coyote moment,” but the economic logic has not changed.

Paul’s thesis adviser was Mr. Overshooting, Rudi Dornbusch. You could not complete Rudi’s course at MIT, 14.582, without having the link between current interest rates and market expectations of depreciation tattooed inside your brain. Paul’s prediction in 1985 and this year simply adds a rough calculation as to whether the US trade deficit would become unsustainably large if the dollar fell as slowly as the interest rate gap would suggest.

Here are a couple of quick charts that provide historical perspective. Both are flawed since they are in nominal terms, but they illustrate the point.



References

Bernanke, B. (2005). ‘The global savings glut and the U.S. current account deficit’. Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia.

Dooley, M., D. Folkerts-Landau, and P. Garber (2003). ‘An essay on the revived Bretton Woods system’, NBER Working Paper No. 9971.

Gourinchas, P. and H. Rey (2007), ‘From world banker to world venture capitalist: U.S. external adjustment: the exorbitant privilege’, in R. Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, The University of Chicago Press, 11–55.

Hausmann, R. and F. Sturzenegger (2007). ‘The missing dark matter in the wealth of nations and its implications for global imbalances’, Economic Policy, 51, 469–518.

Krugman, P. (2007). ‘Will There Be a Dollar Crisis?’, Economic Policy, No. 51, 435-467.

Obstfeld, M. and K. Rogoff (2005). ‘Global current account imbalances and exchange rate adjustments’, Brookings Papers on Economic Activity, 1, 67–123.

Footnotes

1 Krugman present the first draft of the paper on which I have based this column in February 2007 at the Economic Policy panel held in New York.

2 The famous cartoon, see http://looneytunes.warnerbros.com/stars_of_the_show/wile_roadrunner/wile...

3 For an early analysis of this problem see Krugman and Baldwin, "The Persistence of the US Trade Deficit", Brookings Papers on Economic Activity, 1:1987, p. 1-43.