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I am dared to believe the dollar is undervalued
Paul Krugman writing in Economic Policy estimates that at a real dollar depreciation rate of 2% per year the US is headed for a steady-state capital-account position of -15 months' GDP, and that at a rate of 4% per year is headed for -7 months' GDP. Yet foreigners--both private and central bank--are not demanding any yield premium on US assets.
This worries him, very much: situations in which large numbers of speculators, investors, and financiers hold irrational expectations are situations that could rapidly move southward overnight should reality intrude into the mind of the capital market.
Link here. I know full well that in most sensible intertemporal models the U.S. dollar is overvalued and must fall further to set right the trade balance. But these same intertemporal models don't explain business cycles or unemployment very well (they do at times, but that's it), so why should they explain currency values? Nor do these same macro models command the full loyalty of Krugman and other pessimists in different settings.
I do know that purchasing power parity predicts long swings in exchange rates to some crude extent, and right now I'm dead set against family summer vacation in Europe. So I will accept this dare and assert that the U.S. dollar is undervalued in world currency markets.
Posted by Tyler Cowen on November 14, 2007 at 04:01 PM in Economics | Permalink
Comments
Oh, snap! I can't believe he actually asserted it!
Posted by: josh at Nov 14, 2007 4:11:26 PM
-Inflation in the system - everything is up by any rational measure and anyone who shops for themselves (tuition, insurance, medical premiums, energy and now food). The only deflation is in items that you perhaps buy once every two years. Raw materials prices indicate plenty more to come in the system.
-The US has signaled a capitulation on the dollar, by dropping interest rates
-The last TIC report was negative
-Trade deficit
-A potential disaster looms in credit derivatives though people only call this is a subprime problem presently, which will probably require even more printing than has been taking place by the Fed
and you are bullish on the largest market in the world that is traditionally set only by the longs who must now by any measure be reducing their buying of the US dollar?
I beg to differ, Sir. The dollar, long term, has a long way to fall.
I have admittedly, not read much of your blog yet, but I hope to change that going forward. By the way, I saw you at the economist debate - very impressive performance - you swayed my initial vote in your favor.
Posted by: ST07 at Nov 14, 2007 4:25:30 PM
Bold words, Professor Cowen, but can you back them up with a purchase of dollar-long currency options?
(Sorry, been playing too much Alpha Centauri.)
Posted by: Person at Nov 14, 2007 4:36:03 PM
Long term the dollar will fall relative to certain currencies. China is growing in economic stature, and as a result will probably have a stronger currency on a relative basis.
Then you have the issue of how things like the trade deficit are measured. It measures dollars per sale rather than profits. Apple probably makes a lot more profit of an iPod than the overseas manufacturers of its components. They then use those profits on R&D (and that is counted as consumption in stats), which yields more profits over time.
Then you have special situations such as Canada, whose currency has appreciated against almost all developed countries, becuase of their windfall commodities profits driving their economy. Oil also accounts for about one-sixth of the U.S. trade deficit, and the dollar has a strong inverse correlation with oil.
Then you have the lowering of interest rates, which will be a drag on the dollar too.
I won't go so far as say the dollar is "undervalued", but I do not necessarily see the fall in value as a sign of the apocalypse either. I also do not feel it is overvalued either.
Posted by: mcwop at Nov 14, 2007 4:41:00 PM
It's no secret that the Euro has been the disproportionate beneficiary (victim) of the global overvaluation of the USD. The same cannot be said of the Asian currencies who continue largely to peg their currencies to ours. So Tyler, you may be right about that European vacation. I would go to Asia before it too becomes unaffordable to Americans.
What I cannot figure out is how and where the inevitable inflation that we are creating through our accumulation of massive internal and foreign debt will play out. Devaluation is always in the interest of foreign debtor nations. "Our currency, your problem," as Mr. Nixon famously said. But will the wave of inflation also be exported? Seems to be happening in China already.
Posted by: martin at Nov 14, 2007 4:45:32 PM
Martin, while the U.S. has debt, many others countries have far more realtive to things like their GDP. In the U.S. there is about $54 trillion in household wealth (stock holdings, home equity etc...), which makes the overall U.S. balance sheet look pretty good.
Posted by: Mcwop at Nov 14, 2007 4:59:50 PM
Cue Robin to ask how much you've bet on it....
Posted by: Eric Crampton at Nov 14, 2007 5:20:14 PM
Uh huh...
Mind you, as a European I would be quite happy to see the dollar rise a bit. That - of course - would also mean that the Chinese currency would rise. :)
Problem is, almost everyone is now expecting another drop in US interest rates (like the last 0.5 and 0.25% drops). Not to mention that your current US administration is likely to borrow another couple of hundreds billion dollars from foreigners in 2008.
I´ve read that during the current US administration, US federal debts rose from around $6 trillion to around $9 trillion? In six years. If true, is that supposed to inspire confidence in the US dollar?
And Mcwop.
Remember the 2000 stock crash? And the current fall of house prices in many regions?
So, I´d be a bit careful about "household wealth". Depending on the region, your house might be a little bit less worth than you thought.
Anyway, that domestic "household worth" doesn´t say anything about your ability to pay foreign lenders, I´d think? For that, you´d need cash, as in household savings.
Remember that back in the 1980s and 1990s the Japanese home equity also looked pretty good. :)
Posted by: Detlef at Nov 14, 2007 5:30:00 PM
A good rule of thumb in such matters to be on the contrarian side. Since most people predict further decline, I am inclined to predict a rise over the next year.
Posted by: Yancey Ward at Nov 14, 2007 5:36:09 PM
Detlef since 2000 our capital markets have appreciated quite nicely, and are still liquid. Not to mention the large amounts of foreign stocks on that balance sheet. The current fall of house prices has not wiped out home equity. And actually wealth does say something about the ability to pay back foreign lenders. Assets exceed liabilities.
The sky is not falling.
Posted by: Mcwop at Nov 14, 2007 5:38:48 PM
PPP holds in the long run. Given that, the US dollar is very much undervalued. I don't really see too much difference between now and, say, 2004, when the dollar went on to recover almost twenty percent on the Euro.
Also, as house prices fall, the lifecycle model would make us believe that cash savings should increase, therefore consumption of foreign goods should decrease, therefore the dollar should improve.
Posted by: cure at Nov 14, 2007 10:28:37 PM
Forget going to Europe, where will I go in Florida with all the Europeans throwing money around. Not to mention those Canadian Snow Birds. Of course my company will be so busy expanding to meet international demand may not have time for a vacation.
Now if we could just get those foreigners to buy some properties in Miami, Bakersfield, Detroit, and Cleveland we might get somewhere.
Posted by: DanC at Nov 15, 2007 12:05:36 AM
Well, lets go long on the dollar Tyler. Great chance to see if you are correct and make some $.
Somebody actually thinks that a vacation to Europe and Florida are equivalent? Its simply amazing
to see somebody state (almost boastfully) they would rather go to Florida then Europe. Amazing. Maybe
if they put in more TGIF, Strip Malls and franchises the South of France could become as appealing as Florida....
Idiocracy here we are.....
Posted by: robert at Nov 15, 2007 12:43:24 AM
Forget going to Europe, where will I go in Florida with all the Europeans throwing money around. Not to mention those Canadian Snow Birds.
Sadly, due to introduced security measures, the US is not quite as inviting to foreigners as it used to be... Sad timing that.
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Posted by: gordon264068 at Nov 15, 2007 7:18:34 AM
Did everyone miss Bernanke's speech? Short-term rates are falling, but my guess is the Fed is about to trap the dollar bears by announcing a suprisingly low long-term inflation forecast, essentially binding the Fed to reduce money supply as soon as the current financial dislocations are finished.
I think the dollar bottom has already been reached in terms of market forces. Money supply is decelerating, trade deficit is recovering (doesn't matter economically but psychologically for all the people who actually listen to Krugman), and every idiot knows to short the dollar. China has just clearly stated they won't be selling dollars, which is the shoe everyone was waiting to drop.
Posted by: 8 at Nov 15, 2007 9:14:41 AM
I should have said economic forces, not market forces. The market could take the dollar lower for a long time, maybe until January 2009?
Posted by: 8 at Nov 15, 2007 9:24:34 AM
robert,
I think before someone accuses another of living in an idiocracy, that person might first learn how to read. DanC wasn't equating the two locales as vacation experiences.
Posted by: Yancey Ward at Nov 15, 2007 10:19:52 AM
Is the purchase of US Treasuries by the Central Bank of China a 'rational' act? Aren't they buying them to keep the yuan/dollar pegged, or to limit the rate of dollar depreciation against the yuan. Is China's trade surplus with the EU significantly less than their surplus with the US, so they would have more incentive to keep their products affordable in the US, with less attention to the EU where they may sell significantly less products.
Posted by: winstongator at Nov 15, 2007 10:40:02 AM
Undervalued against what?
The USD is way undervalued against EUR
The USD is way overvalued against the RMB
The USD is moderately overvalued against the YEN
It all depends on what we're talking about. Because the EUR floats and the RMB does not, dollar bears have excessively bought the EUR, driving EUR - USD cross to an insanely unjustifiable level.
Posted by: joe at Nov 15, 2007 12:19:45 PM
Huh? As a non-economist, I understood little of the discussion above. Can it be written in a way that the average post-graduate degree holder can understand?
I am not sure that there is any validity to saying the dollar is overvalued or undervalued when discussing the currency markets. The markets are very open. My understanding is that the value of the dollar (in floating currencies) is driven by supply and demand. From this, I conclude that, from the day that the dollar was floated, it was neither overvalued nor undervalued.
Of course, there are factors that can affect the price of the dollar. The US government can produce more of them. Other governments or large dollar holders could disgorge a substantial amount of dollars on the market. People can like dollars and be willing to pay more because the US is so awesome. Banks can offer a higher rate of return on dollar savings. And the value of companies priced in dollars can go up.
I am worried that the value of the dollar has declined. I am worried because I believe that it is due to bad economic policies. I do not believe it has anything with the price of the dollar being "wrong". IMHO, the policy of the government should be to make dollars more valuable.
Posted by: Allan at Nov 15, 2007 3:11:17 PM
I am not so sure about the overvaluation of the dollar.
I live in Denmark, and our valuta the DKR is pegged to the Euro.
I made a little survey for about 6 weeks comparing supermarket prices in Denmark and in the USA.
If you remove sales taxes and VAT, the real value of the dollar in a supermarket is about 56-60 eurocents. Today the exchange rate is about 68 eurocents to a dollar.
If you look at IKEA which is both in Europe and the USA and make the same comparation, IKEA values 1 dollar to 52 eurocents.
I think the dollar is going through a "controlled" gliding devaluation, and I think the goal is 1 dollar to 60 eurocents.
The FED and the ECB has a common interest in the project.
The FED can in that way get writ of a good deal of the American foreign debt, and the ECB can help the Euro to be a new international reserve valuta. At the same time, the EU has only a small part of the dollar reserves, so their losses will be relatively small.
The real losers will be the countries in the far east, that has invested heavily in dollars.
That's why the ECB keeps up the rates, while the FED lowers their rates.
By the way, the USA is not the largest economy in the world.
In 2006 the US GDP was 13.000 billion USD, and the GDP in the EU15(the "old" EU)11.400 billion €.
With todays exchange rate that is 16.764 billion USD, or about 29% larger than the US GDP. Maybe that's the reason for the shift in reserve valuta.
With a foreign debt of 60% of GDP a large internal public and private debt and a negative private saving rate (-2% in 2006) the US economy is in a relatively bad shape, and on top pf that is the sub-prime crisis.
So it is not likely, that the USD will revaluate in the short run.
Posted by: Mogens at Nov 17, 2007 6:06:37 PM
The Euro has been over 1,30 a few times in the past years on spikes but the average annual rate for the Euro/$ has been just over 1,25 in 2004, 2005 & 2006. It is only in 2007 that the Euro has traded consistently above 1,30 so it might be premature for the European decision makers to proclaim Euro land can cope with a real strong Euro. The markets are very selective in what they want to see ignoring for example that Euro land has higher government debt as a percentage of GDP, worse demographic trends, worse problems assimilating immigrants. Add to this certain countries were allowed in by fudging official economic data and nothing happens if member states break agreed limits on max. budget deficit as percentage of GDP and deficit/GDP ratio.
Of course it is also ludicrous to use mostly German economic performance (25 % of the population in the Euro area) to justify the market rate for the Euro. France, Italy and Spain as a block have almost double the population of Germany.
But remember if you are a believer the dollar is clearly undervalued you can take solace in the fact the same “financial gurus” that now think 1,48/1,50 is fair value are by large the same who 5/6 years ago thought the correct value to be 0,85 or going back a little further thought 1:1 Pound/$ was justified.
Posted by: Ingvar Strom at Nov 23, 2007 8:15:53 AM
Mogens, I am curious, how do you reconcile that survey of supermarket prices in the US vs Denmark, stripping out VAT and sales tax, with the PPP measured by the Economist's Big Mac index? Are the VAT rates huge in Denmark (well over 50%)? I used to live in Europe, but I am now too out of touch to have my own intuitive feel for which currency has more PP.
Thanks IA
Posted by: pt at Nov 24, 2007 9:48:49 PM
Posted by: 鑽石 at Apr 2, 2008 11:24:29 PM
