Where Does the Buck Stop?

Investor’s Business Daily cavalierly dismisses worries about America’s twin deficits and declining dollar.  IBD is not bothered that even the normally more sanguine Alan Greenspan has chimed in with a warning that the deficits "cannot continue to increase forever."

With all due respect to the
"maestro," he really shouldn’t worry. And neither should you.

IBD’s explanation is likewise cavalier.

One, the Fed has held real interest rates below zero for a prolonged
period. It has printed money to keep the economic expansion on track.
Two, the dollar isn’t plunging against all currencies; it’s mostly
falling against the euro.

Exactly. Interest rates were held low because the economy had slowed and needed stimulating (don’t forget that policymakers at one pointed even feared deflation). Low interest rates were a necessity, but implying that they characterize economic strength is a bit much. Now the pendulum is beginning to swing the other way, and Greenspan and company are having to think about what happens in a more inflationary environment. The weakening dollar also weighs on the minds of traders worried about inflationary forces on the U.S. economy.

And why has the U.S. dollar mostly fallen against the Euro and not against the Asian currencies? Well, as we have stated before, the Asian countries continue to help prop the U.S. dollar through their purchases of our Treasuries and other securities; they do so because they need us to keep buying their products. As long as they stay comfortable doing so, IBD can keep happily peddling its bullish scenarios in its newspaper. But if some of these net buyers of our securities finally start becoming a little more anxious about our country’s fiscal health, there could be a problem, says Bloomberg’s Andy Mukherjee:      

There’s another important reason why Bretton Woods II may
have to be dumped. Nouriel Roubini, a professor of economics at New York University’s Stern School of Business, says that the current global financial system can be sustained only if Asian central banks act as a cartel and keep their existing and future reserves in U.S. dollars.

There is, however, no formal cartel. As a result, every Asian central bank will want to protect itself against an erosion in the value of its assets from a decline in the dollar. In other words, what’s in the interest of one Asian central bank isn’t for all. Social scientists have a name for this phenomenon: “Tragedy of the Commons.” [Actually, "prisoner’s dilemma." –Wayne]

“All central banks may be better off if no bank tries to diversify its reserve holdings,” Roubini says, “but as the risks of dollar depreciation grows, each central bank has an incentive to defect and to try to protect itself from losses.” Losses could indeed be large. Asian central banks own more than $2.2 trillion in foreign-exchange reserves out of a global total of $3.4 trillion.


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