Abandoning the Dollar

Doom and gloom announced as two countries announce that they are diversifying their reserves out of the US dollar. It\’s not so much the two countries (Qatar and Vietnam) as what that might mean for other larger ones.

However, as Dean Baker points out, this isn\’t a bad thing at all: it\’s actually an excellent one.

The dollar is declining for a simple reason — it was over-valued. The United States had a trade deficit that exceeded 6 percent of GDP at its peak. This was not sustainable, as just about all economists recognized. There are two ways to reduce a trade deficit: a recession or a fall in the dollar.

Unfortunately a falling currency doesn\’t immediately cut a trade deficit: there\’s something called J-curves which can have the effect of increasing it in the short term (prices are sticky, see). But with a high trade deficit yes, a falling $ is what we would actually like to see, not something to be feared (unless you are, like me, someone who gets paid in $ and spends in € but then the world economy isn\’t there to please me).

3 thoughts on “Abandoning the Dollar”

  1. The dollar isn’t necessarily overvalued though – according to the Big Mac index it’s actually 22% undervalued relative to the Euro. Obviously the Big Mac index is not meant to be taken 100% seriously, but the point it makes about PPP is certainly valid.

  2. I thought the mantra used to be that US current account deficit simply reflected the rest of the world’s confidence in the US, shown through investment flows?

    Tim adds: That’s certainly been one of the stories. Not inconsistent though. The US dollar has remained high, thus causing the trade deficit, and now, as investors lose that confidence they reduce their holdings of dollars, lowering the price and thus closing the deficit.

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