November 8, 2007, 5:51 pm
Dollar doldrums
I won’t say this often, but Dan Froomkin is wrong here. I blame Bush for a lot of things, but the declining dollar isn’t one of them.
The basic issue is that sooner or later foreigners will stop lending America the money to spend more than it earns. Because Americans spend a higher fraction of the marginal dollar on US goods and services than foreigners do, any rebalancing of global spending reduces the demand for stuff made here. And the only way to avoid having that cause a recession in the US is for US goods and services to get relatively cheaper, which in practice means a fall in the dollar.
And it doesn’t matter much what we were spending the money on. Bush’s priorities are all wrong, but regardless, when US spending has to fall by $500 billion a year, the dollar has to fall with it.

Second, can anyone offer an explanation of what he means? I think I understand it at a superficial level, but what does he mean by "when US spending has to fall by $500 billion a year"?
Has to fall?
Is he saying that Americans are spending less right now, for various reasons. And that creates a shortage of demand in the US. And to avoid a recession, then our prices have to drop for foreigners so that exports can compensate for the lack of demand here? And if that's so, I still don't see why falling prices necessarily mean a falling dollar.

However, contrary to a widely held belief within the economics profession, devaluing the dollar is itself no panacea for correcting the savings (trade) imbalances across countries. The accompanying paper in this volume – “Exchange Rates and Trade Balances under the Dollar Standard”, by Hong Hong Qiao (2007) – shows that, unlike what the old and familiar elasticities model of the balance of trade would suggest, having creditor countries like Japan or China appreciate the yen or renminbi against the dollar would have no predictable effect on their trade surpluses. In effect, their savings surpluses (or the American saving deficiency) need not be corrected if the dollar is devalued. Nevertheless, any such major change in the dollar’s nominal exchange rate could create serious monetary imbalances in the world economy: deflation in the appreciating countries or inflation in the United States, with the tradeoff between the two being somewhat arbitrary (McKinnon, 2007a), but where any long run impact on the “real” exchange rate washes out. Instead, correcting international trade imbalances must start with countries’ changing domestic absorption, i.e. aggregate spending, relative to income. International adjustment requires that net saving be increased in the United States or reduced abroad—particularly in East Asia.

If we use the terms-of-trade (most common) definition of the “real” exchange rate, there is no presumption as to which direction, if any, the real exchange rate need move to facilitate the transfer in the long run. And, in the short run when export prices are “sticky” in each country’s home currency, there is no presumption as to which way the nominal exchange rate should change either...Dollar depreciation would impose an unnecessary secondary burden on the United States as the terms of trade turned against it in the short run, although any real depreciation would eventually unwind in the long run. Because domestic export prices are sticky in the short run, a stable nominal exchange rate would have the great advantage of keeping the terms of trade fairly constant—rather than fluctuating unpredictably as mutual absorption adjustment proceeded.Without devaluing the dollar, U.S. net exports would gradually increase anyway.

Would restoring fiscal balance help America's overal economic outlook and strengthen the dollar?

November 19, 2007,  1:41 pm
Thinking about the dollar
I have to do some teaching on the subject of the falling dollar and whether it’s recessionary. So herewith some ruminations. WARNING: FAIRLY WONKISH.
First, we need a model. My starting point is to think of the Fed as setting “the” interest rate (more on that later), and facing two tradeoffs. On one side, the lower the interest rate the higher is employment. On the other side, the lower the interest rate the lower the dollar. In normal times the Fed tries to set the interest rate so as to achieve more or less full employment, and lets the dollar fall where it may.
Now along comes a change in investor expectations that makes the dollar weaker at any given interest rate. This also, with some lag, makes the economy stronger at any given interest rate, because a weaker dollar means stronger exports and less imports.
So what would we expect the effect of changing expectations that weaken the dollar to be? We’d expect it to lead to a weaker dollar (duh) and also higher interest rates — but the latter effect would happen only because the Fed is trying to offset the expansionary effect of that weaker dollar. It shouldn’t depress the economy at all.
OK, so how do we make this story more pessimistic?
One way is to argue that the Fed will have to raise interest rates more than is necessary to stabilize employment. The usual reason given is that the falling dollar will be inflationary, so the Fed will have to support the dollar with higher interest rates to ward off this inflation. OK, this could be right, but I have a hard time making the numbers look big enough to get worried about: imports are only 16 percent of GDP, and exchange rates are much less than fully passed through into import prices. The big dollar fall from 1985 to 1988 wasn’t notably inflationary.
Another argument I used to make was that a dollar plunge would pop the housing bubble, setting in motion a rapid fall in domestic demand that would outpace any rise in exports. But the bubble popped all on its own, so I don’t think this is still valid.
Finally, there’s a fairly subtle argument about term structure and timing.
You see, the Fed only controls short-term interest rates, while investment spending depends on long-term rates. Meanwhile, the effects of a weak dollar on exports take a while, maybe as much as two years, to take full effect.
So there’s a story that runs something like this: a plunging dollar will eventually be very expansionary, and will force the Fed to raise rates to cool off the economy — not now, but a year or two from now. But the expectation of this future rise in short-term rates will push up long-term rates now, causing a recession even if the Fed does nothing.
This story depends on the effect of interest rates on demand working faster than the effect of the exchange rate on exports.
I guess this could work. But it’s a fairly tricky story, and a lot subtler than the alarm I’ve been hearing.
There’s always the possibility that I’m missing something big, but right now that’s where my thinking is.

Krugman is basically saying that a negative savings rate is due to us consuming more than our income which we were able to do by putting our houses up for collateral.