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December 09, 2006

 €1 = $1.33

The slide of the dollar seems a matter of indifference to most Americans. (Visiting Washington a few years ago, I was surprised to find that the dollar-euro exchange rate could only be found deeply buried in the financial pages of the WAPO; in France, it's included in the hourly financial news bulletin on the main radio news channel. This is absurd, but shows the sensitivity bred by the decades of pre-euro vulnerability.) Even an expert like Brad DeLong highlights the one-hand fact that the fall has raised the dollar value of American assets abroad by $400 billion. Me, I'd worry a bit more about the other-hand consequence that the value of foreign assets in the USA has gone down by even more, and the holders are in a position to do something unpleasant about it: sell.

Is a run on the dollar possible?

The conventional wisdom has it that speculative attacks on a currency are basically a problem with pegged rates. In the right circumstances (which are not rare) they create one-way bets for the likes of George Soros. The solution is to float (or irrevocably fix in a currency union). As a categorical assertion, this commits the fallacy of the excluded middle here: pegged rates are vulnerable to runs, ergo floating rates are always safe. They are safer, but do the floating prices of stockmarkets protect investors from the risk of bubbles and crashes? In the right circumstances - which will be rare - surely a floating currency can be subject to a run, a panic in which many investors bolt together for the exit because they believe that others are doing so.

The USA finds itself, by the combined thriftlessness of its government and its consumers, in a deep debt hole. In 2005, US net indebtedness was $2.7 trillion. Foreigners held $2.4 trn in liquid government securities, and $2.1 trn of equities. The majority of the government securities are held by government agencies such as central banks, the majority of equities by the private sector (here, table 1.6). With the current account deficit running at ca. $800bn a year, the current figures are that much higher. US GDP is running at $12.5 trn so the annual deficit is 6% or so of GDP, or 2 years' growth; the net indebtedness 30% or so.

It' s CW that the former is unsustainable. What about the latter? The likeliest scenario is perhaps the rosy one: the US still offers a vast range of investment opportunities to foreigners, and where else can they put their savings, including trade surpluses? But suppose a fraction are upset by the losses they have suffered, conclude that the dollar still has a long way to fall, and start selling; or a sharp decline is triggered by hedge funds, and bond and equity-holders lose their nerve and panic. Private-sector holdings would be quite enough: the likely rebalancing of reserves away from dollars by central banks will further the current decline, but I can't see them joining in the run.

A run on the dollar today would have to be on a catastrophic scale, never seen before. But catastrophes do happen. The forced exit of the pound sterling from the ERM in 1992 ("Black Wednesday") cost British taxpayers 3.3 billion, mainly in lost appreciation of currency reserves. George Soros alone shorted the pound by $10 billion. Taking 25% as the devaluation (1=DM 2.95 to DM 2.20), the total speculative sales must have been of the order of 13bn, or $25bn at today's exchange rates. That's chickenfeed in today's financial markets. A run of $500 billion on the dollar, only 10% of total foreign assets in the USA, would be unmanageable; US government foreign currency reserves are only $66 billion, not much more than the $52 billion claimed by Iran. BTW, wouldn't you expect Iran to be drawing up contingency plans for sparking a run to deter US military adventures?

The Fed would have to close the markets, after vainly hiking overnight borrowing rates to - what? 50%? Then the men in black - Rodrigo Rato, Jean-Claude Trichet, Zhou Xiaochuan - would show up with generous offers of help to calm the markets when they reopened, contingent on lectures on financial responsibility and a few minor policy adjustments - say a $1 a gallon tax on gas, the repeal of Bush's tax cuts, and a 2-year increase in the pension age, effective immediately.

Americans, both policymakers and citizens, would I think be quite unprepared for this situation. It's humiliating, but many other countries, including the UK, have had to endure it, and sympathy will be in short supply. The many financial panics in American history have been essentially domestic affairs.

The realization of dependence on the rest of the world in this way would be a most unpleasant awakening. I hope it happens more gently, but one way or the other, it surely will.

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