Friday, December 24, 2004

DeLong Asks


So why is it that those who focus on exchange rates ("falling desire to hold dollar-denominated assets reduces the value of the dollar") are more likely to see a happy, balancing-up resolution while those who focus on the circular flow ("falling desire to hold dollar-denominated assets leads to a sharp fall in the financing available for investment and a spike in interest rates") are more likely to see an unhappy, balancing-down resolution?

I don't think this should be a big mystery. In the former line of thought, the falling dollar reduces demands for imports, shifting some expenditures towards more domestically produced goods (increasing wages) and perhaps some into additional future consumption, raising the national savings rate. In the latter, an interest rate spike does not lead to higher national savings because a significant portion of our country are net borrowers, even excluding their home mortgage or other secured debt, and not net lenders. Rising interest rates will raise interest payments for consumers with heavy consumer debt, and for people who got ARMs with shitty terms. The US continues to borrow from the rest of the world at ever higher rates.

My economist hat is getting rusty, but I think it's whether one is worried about the fallen dollar or the falling dollar. Presumably, had pure small economic agents expected a giant drop in the dollar over the past year, interest rates would have spiked back then. But, most likely because big players in the market are not pure small economic agents, but governments of significant countries, interest rates were kept low. If these players continue to prop up the dollar even as it falls, or if the dollar's value is expected to stabilize, then there's no reason for the dollar's previous fall to affect current demand for US financial assets.