Menzie Chinn on the Prospects for the Dollar

For those who have somehow missed it, Econbrowser does a consistent job of presenting economic data and trends in a thoughtful yet accessible fashion. And they usually have tons of charts.

Menzie Chinn, an economist who has written about currencies, in “A Tipping Point for the Dollar?” gives an update in light of the continued drubbing of the dollar. I recommend reading his post in its entirety, and he has three main observations. First, there is no evident support for the dollar’s value. Second, the dollar’s slide has made foreign investors perceive US dollar denominated assets to be more risky than before (the risk premium they assign to holding dollars has risen). Third, while large, mature economies generally adapt relatively smoothly to changes in currency values, the conditions may be in place for a disruptive shift.

We have pointed out before that by trashing its currency, the US is risking one of its most powerful advantages, namely, its status as reserve currency, which allows us to denominate foreign debts in US dollars. Imagine the difficulties that would ensue with the dollar’s recent fall if our debts were denominated, say, in euros. And there are signs that key players, such as China and the Gulf states, are diversifying away from the dollar.

For someone as sober-headed as Chinn to allude to systemic risk in the context of currency movements is revealing.

From Econbrowser:

My prediction was largely vindicated on this point; the dollar has taken a beating and most prognosticators do not see an obvious floor to the value of the dollar, at least against a basket of currencies (1.40 USD/EUR is sometimes cited as barrier). In euros and in trade weighted terms, the dollar has broken long-time barriers….

What I did not incorporate into that prediction, but alluded to in other posts, is the idea that dollar denominated assets might become less desirable — holding asset returns constant — vis a vis assets denominated in other currencies. One way in which this could occur is via shifts in reserve accumulation. This is occurring, although the extent is difficult to gauge,,,,

…it is clear the prime driver of the re-evaluation of the desirability of dollar denominated assets is now the increasing perceived riskiness of bonds associated with the collapse of the sub-prime mortgage market.

Will this be the beginning of the hard landing? In the models I teach to my students, “hard landings” do not occur in well-functioning open macro-economies. As dollar denominated assets become less desirable, the exchange rate depreciates, US interest rates rise, and the economy adjusts to these new relative prices. Sharp asset price changes are possible, but they can be completely rational in nature.

However, when times are unusual, smooth adjustments might be derailed by interactive effects. In other words, the world might be nonlinear when financial markets are stressed. The particular nonlinearity I have in mind here is the interaction between higher required interest rates on dollar denominated assets necessary to attract capital inflows, and the already fragile private bond markets. Without greater knowledge of how hedge funds are positioned and it’s hard to say what will happen. But it is exactly situations like this — where the financial markets are poised between stability and volatility — that the previous experience with large US current account adjustments (such as that recounted by Croke et al. (2005), or Freund and Warnock (2005)) is of limited relevance.

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    So let’s see, what currency *other* than the dollar would you want to hold? JPY? Isn’t doing so well. GBP? Has many of the same problems as the US. CHF? Too small. That leaves, I guess, the Euro. And the Euro has political problems, because the Eurozone is not yet built as a single political unit. France doesn’t like the Euro at its current level, and Germany does. If the Euro continues to appreciate against the dollar, then the French are going to be even more unhappy, and some other countries (like Italy) will rally to their banner. The French are brilliant at getting their way; because when they don’t, they’re perfectly willing to pick up their marbles and go on. In brief, the more the Euro rises, the more there is risk that the Euro just falls apart, in which case the Euro is worth squat.

    So the only thing holding the dollar together is that there are no great alternatives. This isn’t a prediction about the usd/eur rate. (I, for one, would sure like it to hit 2, so I can change my money away from euros…)

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