Monday, November 14, 2005

The US rope trick, or how to keep the dollar up

The deficit is at a new high but the greenback defies gravity. Where's the logic?

Burn the textbooks. Forget that fuddy-duddy stuff about demand and supply. Blow a raspberry at economic theory. That, apparently, is the message being sent out by the foreign exchange markets, where the dollar reached a two-year high against the euro and the yen last week.
But isn't it the case, I hear you ask, that the United States notched up a record trade deficit of $66.1bn last week - equivalent to 6% or so of its gross domestic product? Yes it is. And isn't the US financing that trade deficit by flooding the global markets with dollar-denominated assets that are snapped up by its creditors? Right again. And when the supply of something goes up, isn't it customary for the price to come down? Full marks for impeccable logic.
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When you get down to it, there are only two reasons for an appreciating dollar. One is that it is going up because it is going up; the herd mentality of markets means that you do what everybody else is doing even if you think they are wrong. The second is that the markets have deluded themselves into thinking that a country that is spending one dollar and six cents for every dollar that it is earning doesn't have a problem.

The fact that the Chinese, the Japanese and the other big exporting nations of Asia are colluding in this financial fantasy should come as no surprise. A strong dollar is wonderful for these countries since it helps them to build up their industrial - and, in China's case, political -power even as American manufacturing is hollowed out.