Our currency and our problem
From the Financial Times:
I fear, however, that the good news about dollar weakness for the US is about to come to an end. Sooner rather than later, the weakness of the dollar, and fear of its future weakening, will trigger a large increase in long-term US interest rates, nominal and real. Today’s papers reported how at the OPEC meeting, the cartel members discussed making a statement to the effect that the weakness of the US dollar meant that higher dollar prices for oil and gas were justified. The fact that it was Iran and Venezuela pushing for such a statement does not mean that this view is restricted to declared enemies of the US government, or that it has no merit. Many of the oil exporters continue to be large holders of US government debt. They want to get out of as much of it as they can, but perceive a steeply downward-sloping demand curve for rapid sales. Nevertheless, all the incredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood. The stock of US government debt outstanding can, however, only be reduced through US government budget surpluses, and we are unlikely to see many of those. So when the dust settles, the existing stock of US government debt will continue to be held, but at a much lower price (higher yield) and at a much weaker external value of the US currency.
The further weakening of the US dollar will continue to boost the tradable sectors of the US economy, but any sharp increase in long-term nominal and real interest rates will hit investment spending everywhere, and the non-traded sectors like residential and non-residential construction in particular. It won’t be pretty. Expansionary monetary policy measures will be limited because a collapse of the dollar will have non-trivial inflationary consequences. That ugly word ’stagflation’, will raise its ugly head.
With US long-term real interest rates now set largely by world markets rather than by domestic monetary and fiscal policy, the US policy makers will have to get used to operating in a setting that is quite unlike the closed economy paradigm that they grew up with, and more like like a small open economy. On the financial side, it has, effectively, already happened.
Posted on 2/28/2008 10:23:22 AM by TMassApproved 3/3/2008 10:21 PM