Saturday, October 25, 2008

Thinking About the Dollar

The U.S. may be heading into its worst recession in 40 years. Normally, such a development would result in a declining U.S. dollar. Instead, the dollar is strengthening as seen in the figure below which shows a weighted average of the dollar against its trading partners (click on figure to enlarge):

So what explains the rapid appreciation of the dollar? Bloomberg says the following:
Oct. 25 (Bloomberg) -- The dollar gained the most in 16 years against the currencies of six major U.S. trading partners as a global economic slowdown spurred demand for the greenback as a haven from losses in emerging markets.

``The foreign-exchange market is basically saying we are in a global recession and perhaps a very, very deep one,'' Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York, said in an interview on Bloomberg Radio.

[...]

``We are in a financial crisis,'' said Richard Clarida, a global strategist at Newport Beach, California-based Pacific Investment Management Co., which oversees $830 billion in assets, including the world's biggest bond fund. ``The flight to quality is boosting the dollar and the yen.''

Emerging-market currencies tumbled as Argentina seized private pension funds, and Belarus, Ukraine, Hungary and Iceland joined Pakistan in requesting at least $20 billion of emergency loans from the International Monetary Fund. Brazil's real dropped 8.2 percent to 2.3075 against the dollar, the South African rand decreased 10.4 percent to 11.18 and the Russian ruble fell 3.2 percent to 27.1991.
So a negative economic shock that originated in the United States--the downturn in the U.S. housing market--has set off a global recession that is causing a flight to the dollar and is thus increasing its value. If this understanding is correct, then I have failed to appreciate the full extent of the exorbitant privilege the United States gets from having the main reserve currency of the world.

Update: Mark Thoma directs us to Paul Krugman, Dani Rodrik, Edward Harrison, and Simon Johnson for discussion on the stresses in emerging markets from the declines in their currencies.

2 comments:

  1. Im no economist, but I have a different theory..... Since almost all modern money is created by the issuance of debt, and since the Dollar and the Yen have been the cheapest debt to be obtained the last several years, I believe a reverse carry trade is occuring where debtors (hedge funds) are being foreced to retire debt to repay leveraged redemptions... this retirement of debt and subsequent liquidation is causing a) deflation in every assett class hedge funds can own (anything exempt?) and b) causing money supply to diminish as debts are retired to meter our redemptions...
    what say you?
    LCDR Neil Colston
    (SW) Texas State 1997

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  2. Neil:

    Certainly the undwinding of carry trades is going on, but that applies more to Japan than the United States. It is Japan that has had interest rates close to zero percent since the mid-to-late 1990s, making it a great place to finance global investments. Even with the carry trades, though, one has to ask why now? The obvious answer to me is a global recession is looming forcing both (1) an unwinding of carry trades and (2) a flight to safety.

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