Krugman says he has been predicting a dollar fall for a long time but that it keeps not arriving. The fundamental issue is not the trade deficit, nor the budget deficit.
The issue is confidence.
The simplest way to put this is also the bluntest. The United States exports global security. It also exports the global model for consumption. This creates two very credible threats in the global world. One is that should the United States find it expensive to run a big military, then it will stop, and the resulting political and economic instability will be worse than whatever the difference in interest rates is. The second is that the United States, to some extent because of research that flows out of the defense establishment, and to some extent because of the ability of consumers in the United States to consume, will be the home of another technology boom, and thus dollars will be in short supply again.
These two credible realities keep foreign entities buying dollars. In essence they do not want to be caught short of dollars. Many of these entities were caught short of dollars before Rubinonomics and the internet boom.
However, these two realities are not immutable and permanent. As the chance of a dollar shortage goes down, so too does the marginal preference for dollars over other currencies. This marginal preference is not going to evaporate over night, which is why the dramatic dollar collapse, so common with other currencies, has not happened.
On the other hand, as a marginal preference deteriorates in the face of mounting evidence that the risks that keep that preference in place have gone down, this creates a relentless downward pressure, one that is hard to reÃ«stablish without significant actions.
Right now, objectively speaking, the chance of a dollar drought is very remote. Neither the fiscal nor monetary authorities in the United States have shown any willingness to take the pain of a recession to reduce inflation, and such a recession would increase, not decrease, fiscal deficits. Currencies heal not with recessions, but with the following expansion. Since the recessionary cycle would last at least two years, it is therefore at least two years – even if everyone in Washington woke up tomorrow and decided to do something about it – away.
The next problem with the dollar is that the United States is losing two wars. One of the reasons to bet on the dollar in the face of the Iraq war is the effect of adding 3million barrels a day to the global oil supply. In 2002 this would have made a significant difference, now much less so.
The next the problem with the US dollar is that it is clear that the body politic in the United States has decided to finance their spending with the twin taxes of inflation and devaluation. Absent the willingness to tax themselves, other entities will rationally wish to avoid paying further taxes.
Finally there is the reality of globalization. With each step of exporting the US supply chain overseas, there is progressively less likelihood that the US will be the home of the next revolutionary technological advance in large scale manufacturing, and less and less chance that during the next boom that some commodity that only the US can make will be in short supply.
Thus we should continue to see what we have seen, not a one day meltdown of the US currency, but a constant and continued erosion, followed by an extended period where the dollar will be very weak compared to other currencies. This will continue until there are clear signs of a change in policy regime in the United States.
The trade deficit, itself, does not matter in this context, except to the extent as to the sphere of dollar holding is getting larger or smaller. In the context of a strengthening currency, a trade deficit can actually work to American advantage, by expanding the number of global entities that hold dollars, allowing the United States to have looser monetary policy than would otherwise be sustainable, and thus greater growth. That is, so long as that growth produces more new goods and services that other nations want to buy. This virtuous circle was the 1990’s. The vicious circle we are now in is that the more the US wastes, the smaller the sphere of dollar holders are, and the more dependent we grow on the ones who are left, and the less likely they see it as being likely that there will be a dollar drought any time soon.
See, Ben Bernanke can’t run a central bank and We have moral cripples for political leaders, parts one through five hundred and seventy three in a continuing series, collect them all.
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