Wednesday, November 01, 2006

Rubin In The Times, Betting Against The Dollar

In today's New York Times the Economix column by David Leonhardt carries the title "A Gamble Bound to Win, Eventually". Its about Robert Rubin, now characterized as the "eminence grise at Citigroup", having lost money betting against the dollar. He isn't the only one to have wagered and lost on this bet. Of course the equally large book taking these bets wagered and won.

This from the article (the he is Rubin):
But when he talks about the dollar, you can see how hard it is, even for somebody with his self-assurance, to remain confident in the face of a failed prediction. “I think I was right, probabilistically,” he said recently, sitting in his Citigroup office overlooking Park Avenue. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.”

Why bet against the dollar in the first place? The article explains:
The simplest way to explain the problem is to say that the United States has been living beyond its means.

Both the federal government and American families have been spending more money than they take in, leaving both in debt. To close the gap between our resources and our spending habits, we have borrowed from abroad. It’s the only option.

The net amount of money leaving the United States — that is, the amount of money we need to borrow back to support our lifestyle — has soared to $800 billion a year. “It’s just stunning,” said Kenneth S. Rogoff, former chief economist of the International Monetary Fund. “It’s unprecedented.”

As for how it can resolve itself, well it can be quick and dislocating or slow and relatively painless. One scenario noted in the column caught my attention:
The other possibility is that an unexpected event — a spike in oil prices, say — could cause foreign investors to cut their dollar purchases sharply, bringing all sorts of economic havoc.


Oil is priced in dollars. A spike raises global demand for dollars and then transfers all of it to OPEC. Petrodollar recycling ensues. Trust me on this one, they don't burn the dollars. They buy lots of things that are priced in dollars -- not all of which is sold by U.S. producers. By the way, know who the world's largest exporter is, in absolute terms? The United States, by a landslide.

The reason so many notables were wrong on the dollar, and this isn't to say that at some point they won't be right, is only one side of the equation is being examined. In other words, they are not open to the possibility that they have cause and effect reversed.

The demand for dollars is NOT something totally in our control. As the global currency, lots of people buy and sell dollars because of their own domestic needs and concerns and not because pricing of U.S. dollar assets are attractive. In fact, as I wrote about yesterday, the Warnock paper on the impact of dollar flows on U.S. interest ratees suggested that flows dropped the yield on ten-year Treasurys by about 90 basis points. Why would foreign capital keep following?

Herein lies the tale, from my perspective. We have, in some ways, become like any other emerging economy where foreign capital flows in and distorts domestic pricing and, in turn, domestic activity. It is not quite that bad, although 90bp is alot when you consider it took 4 Fed meetings to raise the funds rate 100 basis points, since the demand for dollars might reflect activity elsewhere in the world with little relevance to whether U.S. asseets are attractive. But the domestic impact is the same, regardless.

Rather that wring our hands about the profligacy of Amercian consumers and the Federal government, a worthy topic for another time, collective wisdom should focus on how to insulate asset prices here from being distorted by foreign flows. A distortion that, in turn, distorts domestic activity. Ideas?

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