Yesterday I took note of the push and pull forces that are making it awfully hard to predict where short term momentum is for the dollar (and trade deficit) in the current global economic environment. It does, nonetheless, seem indisputable that the longer term forces are firmly in in the direction of reversal in the U.S. current account deficit, and (probably) an associated decline in the value of the dollar. Thus we find our way to the now familiar hard-landing/soft-landing debate.
Brad DeLong weighed in on this just last week -- in a post heartily endorsed at winterspeak -- putting his chips on the soft-landing side of the table:
The domestic macroeconomists would typically argue more or less like this:
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.
To this, the international economists would respond more-or-less like this:
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.
I find myself in an odd position here. I agree with the "domestic macroeconomists" conclusion, but am sympathetic to much of the "international economists" reasoning. I have a third way. Let's call it the "full employment economists" story:
Yes, the dollar is likely to decline 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. The result will be a reduction in the flow of imports into the U.S. that have been allowing consumers, firms, and the government in the U.S. to consume more than the domestic economy is producing. Without the extra goods and services from foreigners, prices have to adjust to bring domestic demand in the U.S. back into line with supply. In fact, demand from U.S. consumers, firms, and the government have to fall by even more than that, because export demand will pick up when the dollar depreciates. The prices that make it all happen are real interest rates, so you better expect that they will rise.
All of this requires a fair amount of resource reallocation, which is always a bit tricky. But if the process is slow enough and smooth enough, there really isn't any reason to believe that there will be a big impact on U.S. GDP and employment growth, one way or the other.
That's my story, and I'm sticking with it.