Krugman: Dollar as Ponzi scheme

[Michael Pollak <mpollak@xxxxxxxxx>]

AUG 01, 2001

Blessed Are the Weak

By PAUL KRUGMAN

   T reasury Secretary Paul O'Neill recently gave an interview in which
   he dismissed claims that the dollar was overvalued, arguing that
   concerns about our trade deficit are based on "trivial and wrong
   notions." He also thinks that concepts like gross domestic product are
   obsolete. I took his remarks as an indication that the dollar's
   inevitable decline will probably come sooner rather than later. And
   while that will be embarrassing for Mr. O'Neill, it will be a good
   thing for our economy.

   Why does Mr. O'Neill's nonchalance suggest that the strong dollar's
   days are numbered? Because there is a clear analogy between the
   soaring dollar and the recent tech bubble. As Robert Shiller pointed
   out in his book "Irrational Exuberance," a gradually rising asset
   price acts like a natural Ponzi scheme, in which each new wave of
   investors creates capital gains for the previous wave. If this goes on
   long enough, it can silence the doubters.

   But eventually the process ends -- and you know that the end is nigh
   when white-haired executives reject old-fashioned accounting. That
   means that the mania has spread to the suits, and that the Ponzi
   scheme is about to run out of suckers.

   The dollar has been rising against the currencies of other industrial
   countries since the middle of the 1990's. This sustained rise has made
   dollar bears look foolish, but it has also priced U.S. products out of
   world markets. Since 1995 the U.S. current account deficit, the
   difference between what we buy from foreigners and what we sell to
   them, has quadrupled to an astonishing $450 billion. It goes without
   saying that this is the biggest such deficit in world history. More
   startling is the fact that at 4.5 percent of G.D.P., the U.S. current
   account deficit is a bigger share of our economy than the deficits of
   Indonesia or South Korea on the eve of the 1997 Asian financial
   crisis.

   In the past, deficits this large have always led to a currency plunge.
   True, one hears arguments to the effect that the rules have changed,
   that this time is different. Those arguments were presumably what Mr.
   O'Neill had in mind when he dismissed concerns about the payments
   deficit. Alas, it would be easier to take those arguments seriously if
   they weren't so similar to the arguments people used to justify the
   high dollar of the mid-1980's, just before it started dropping.

   More ominously, I heard exactly the same arguments -- especially the
   claim that rising productivity justifies a strong currency -- used to
   dismiss concerns about Mexico's current account deficit just before
   the 1995 peso crisis, and again in Asia two years later.

   But would a sharp drop in the dollar be a catastrophe? Probably not.
   In fact, if the dollar is going to plunge one of these days, now would
   be a pretty good time. I wouldn't have said that a year and a half
   ago; but times have changed.

   Not long ago a drop in the dollar would have been a clear negative for
   the global economy. A weaker dollar, which makes U.S. goods cheaper
   compared with the products of other countries, redistributes world
   demand toward the U.S. and away from the rest of the world. Back when
   the U.S. economy was booming, this would have been shipping coals to
   Newcastle; we already had plenty of demand, while other economies were
   depressed.

   Now, however, the U.S. economy has stumbled, and the strong dollar is
   one of the reasons the Fed is having trouble pulling us back from the
   brink. So right now a weaker dollar is in America's interests. It
   still might create some problems elsewhere -- but on the other hand it
   might be just the shock needed to wake the European Central Bank and
   the Bank of Japan from their policy slumbers.

   Is that a call to action? Should we actively seek to drive the dollar
   down? There's a precedent: In 1985 James Baker, who was then secretary
   of the Treasury, organized an international effort to tame the
   too-strong dollar. It's still debatable whether his efforts made any
   difference; possibly the dollar would have fallen in any case. But it
   was a political triumph: Mr. Baker managed to take credit for the
   dollar's decline. Alas, Mr. O'Neill's ramblings have probably
   prevented him from achieving any comparable feat.

   But never mind Mr. O'Neill; the great dollar decline is coming, and we
   should welcome its arrival.

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