Dollar decline: optimism vs. pessimism?

This post by Brad DeLong is excellent. He reports back from Jackson Hole on those who felt a large decline in the value of the dollar would be bad vs those who felt it would not be a big deal.

The optimists would argue

Yes, the dollar is likely to decline steeply either when foreign central banks stop buying dollar-denominated assets to keep the values of their currencies down or when international speculators lose confidence or both. But so what? The fall in the value of the dollar will boost foreign demand for U.S. exports. Workers will be pulled out of other sectors into the export sector. The effects of the dollar decline are much more likely to be a plus for employment rather than a minus, a boom rather than a recession.

The pessimists would say

When foreign central banks stop buying or international speculators lose confidence in the value of the dollar and thus stop buying U.S. long-term bonds, two things happen: the value of the dollar falls, and the rate of interest on dollar-denominated long-term bonds spikes. The spike in long-term interest rates discourages investment spending directly, and also discourages consumption spending because higher interest rates mean lower housing and stock prices and thus lower consumer wealth. The fall in domestic spending happens now. The rise in exports as the falling dollar makes U.S.-made products more attractive to foreigners happens two years from now. In between, a lot of people are unemployed--and as they are unemployed, they cut back further on their spending. Plus there is the risk that the fall in the value of the dollar and the fall in long-term asset prices generated by the interest rate spike will cause enough bankruptcies among financial institutions to cause a flight to quality--which will further raise non-safe interest rates, and further discourage investment and consumption spending

The whole back and forth is very good. At the end, Brad summed up

Martin Feldstein said... the domestic-side economists were keying off the past experience of the U.S. after 1985 and of Britain after 1982, and so were saying "no big deal"; while the international finance economists were keying off of the experiences of developing countries that had run large current-account deficits--Mexico 1994, East Asia 1997, Argentina 2001

Based on this, I am firmly in the optimist camp. I was working at a hedge fund during the East Asia crises of 97 and it was pretty clear to me that the problems there were caused by 1) people holding foriegn assets in local currency and 2) a very homogeneous investor class. When the currency fell, people were unable to make their margin calls and sell into falling markets. Since all investors were in exactly the same situation, no one was capable of stepping in and buying the bargains. Liquidity dried up and the market tanked.

This is simply not the case for the US. Firstly, most US bonds were paid for using dollars. A dollar depreciation is not going to make most bondholders much poorer. Secondly, there are lots of different types of US bondholders, so while some may need to sell into falling markets, plenty of people will be standing ready to snap up bargains. To put it another way, I think the liquidity in US bonds is very robust, and I'm basing this notion of liquidity not on trading volume or depth, but on the diveristy of the investor class.

Incidently, I often rib DeLong as being a frothy nut. In case you think I'm being unfair, read his excellent article and then read the comments left on the site. While Brad cannot be held accountable for who reads his site and what they choose to say, I think it's informative to see who reads his site and what they choose to say:

Let's put it this way. In an idiologically hostile world, why not brings US to its knee and buy the pieces on the cheap? Economist only think about this or that monetary. What if, a shrewed global investor play the game instead?

The question should be asked, then: what does it take to destroy US economy using currency exchange and what precious technology can other countries buy?

Money is just that 'carrier of value', If it worth more to destroy it by gaining a lot of technologie and institutions, why not?

eg. If China destroys 80% of US economy, will walmart suddenly stop importing cotton underwear or Saudi Oil?Who says we are too big to fail. What if Russia and China play our game in the 80's. Let's bring down US and buy out the pieces. Make it beg. How much will it cost? $500B to $1T maybe? It's a good deal if you ask me. Weapons, relative large market, intelectual propterties.

The british empire was also thought to be too big to fail once.

Anybody who thinks The middle east, Russia, China, and India are so needing our market to survive is deluding themselves.The US is openly running a confidence game, relying on past glory and the gullibility of the rest of the world. Well, you can't fool all the people all the time. Remains to be seen when those buyers/lenders will wake up - but wake up they will. Then it'll be an Argentina here, and we'll discover the value of intellectual property in a depression.

The tragedy here is that Economics is such a pathetic science, and fails to offer any real help with these giant blunders. Just a lot of fashionable speculation dressed up with fancy but baseless math.

The other factor OF COURSE is the devastating incompetence and corruption and cronyism of our Rethuglican oligarchy. If the voters don't take a sharp turn away from this crew, we can be SURE that any transition will be completely screwed up, in so far as the govt can screw it up.

Perhaps the deciding factor is really the American voter. If they remain under the sway of the Rethugs, kiss the good life goodbye.