From April 2006!
WILL THERE BE A DOLLAR CRISIS?
Paul Krugman
April 19, 2006
There is little doubt that the dollar must eventually fall from current levels. Trade
deficits on the current scale cannot continue forever – and we’re all fond of quoting
Stein’s Law: “If something cannot go on forever, it will stop.” Closing the trade deficit
will require a redistribution of world spending, with a fall in U.S. spending and a rise in
spending abroad. One occasionally hears assertions that this redistribution of world
spending can lead to the required change in trade deficits without any need for a change
real exchange rates – a view John Williamson once felicitously described as “the
doctrine of immaculate transfer.” In fact, a redistribution of world spending will require a
fall in the relative prices of U.S.-produced goods and services, because U.S. spending
falls much more heavily than the spending of other countries on those U.S.-produced
goods and services. So there must, eventually, be a real depreciation of the dollar. But
this depreciation could be gradual, a few percent per year or less. Why should it take the
form of a discrete drop?
There has actually been surprisingly little discussion of this question, even in papers
that can seem, on a casual reading, to be about the prospects for a dollar plunge. For
example, the widely cited work of Obstfeld and Rogoff about dollar adjustment,
continued in their 2005 Brookings paper, is often cited as reason for alarm. But their
framework is designed to estimate the size of the dollar decline needed to eliminate the
current account deficit; it sheds little light on whether that decline will happen quickly, as
opposed to a gradual adjustment over the course of a number of years.
The closest any paper in the recent Brookings symposium comes to addressing that
question directly is Edwards (2005), whose view is echoed less clearly in a number of
discussions. The basic idea can be summarized as follows: there has been an upward shift
in the proportion of U.S. assets that foreign investors want to hold in their portfolios. As
long as foreign investors are still in the process of moving to this new, higher share of
dollars in their wealth, their actions generate a large capital flow into the United States.
But the capital flows needed to maintain an increased dollar share in portfolios are much
smaller than those required to achieve that share. So once the desired holdings of U.S.
assets have been achieved, the argument goes, capital flows into the United States will
drop off sharply, leading to an abrupt decline in both the current account deficit and in
the dollar.
There are a number of questions we could raise about this story, but one that seems
particularly germane is that of expectations: won’t investors see this coming? If they do,
the dynamics will be very different. The initial shift into dollars, and hence initial capital
inflows, will be damped by expectations of future depreciation. On the other hand, capital
inflows will be sustained much longer, because dollar assets will become more attractive
over time as the dollar drops toward its long-run sustainable level, reducing the need for
further depreciation. So the whole process will be smoothed out. In fact, that’s the
adjustment process described by another paper in the same conference, Blanchard,
Giavazzi, and Sa (2005), which does not imply a dollar plunge. So to get the kind of
sudden stop envisaged by Edwards and others, investors must be myopic: they must fail
to understand the unsustainability of the current exchange rate.
much more (link will open a pdf of his lecture)
http://www.econ.princeton.edu/seminars/WEEKLY%20SEMINAR%20SCHEDULE/SPRING_05-06/April_24/Krugman.pdf
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