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November 08, 2007



As long as those "jittery" markets remain fully liquid, it's all a very welcome correction. I agree (to some degree) with Greenspan's assumption that the correction to the dollar's value (the long-tailed end of dollar exporting) will eventually force some inflation, but that's okay. More worrying would be if a rapid reduction in the value of a dollar created sudden impact to the balance sheets of banks holding large amounts of dollars. If things go slowly, the problem dissipates over time. If too rapidly, then crisis. This is the reason why I feel it's bad to have the savings rate so low and government debt so high, since they increase the pressure on the dollar.

Perhaps this was to some degree intentional, as a way to force China (and others) to allow their currencies to appreciate, but so far I feel it has made things somewhat worse - China has bought *more* dollars to maintain their exchange rate. It's like we're trying to convince them to open up the pressure cooker by increasing the heat, but instead they just reinforce the walls to delay (but increase!) the blast.

I'm not sure what exactly we should do about this, though perhaps simply reducing deficits will take enough pressure off for the dollar to float down relatively gently.


But then, it occurs to me that part of what has inflated the dollar has been its status as a reserve currency - if it floats down and then becomes stable again, will it resume that status? Perhaps not too much, since the Euro seems like a pretty solid alternative and would dilute the degree to which emerging market choose the dollar in any case. Sarkozy, of course, is an example of a Euro-area figure trying to prevent this (since our "loss" is their "gain") and it makes me wonder if Euro-area governments might revolt once it becomes clearer that the Euro had become the dollar's co-reservist. I wonder what the heck they could do about it anyway.

Nathan Smith

Government debt is "so high," compared to what? US government debt is sort of par for the course by international standards, and much lower than some countries', such as Italy's and Japan's.

I'll quibble a bit with the idea that "the savings rate so low and government debt so high... increase pressure on the dollar." The story is, I think, a bit more complicated. A high government debt should have no effect on the dollar, as far as I can tell, if all of it were lent to Americans. That would require more saving by Americans to buy up the bonds, of course. But if you believe the theory of "Ricardian equivalence"-- a controversial idea among economists but with some empirical support-- then government dissaving should stimulate private saving as people anticipate higher taxes and save in order to be able to pay them. A low savings rate-- or a negative savings rate, with lots of borrowing from abroad-- could put downward pressure on the value of the dollar even if there were no government debt at all. The Asian crisis of the 1990s occurred despite low levels of government debt in most East Asian countries.

I don't think it's the *level of government debt* in the US that's problematic, but another aspect of the fiscal system: the transfer of large quantities of wealth from the young to the old. The Social Security system is a frontal attack on the incentive to save. To save is to transfer income from the present to the future. You have reason to do this if you think your income will be lower in the future than it is today. If the government takes money from you now, reducing your present income, but promises to give you money in the future, increasing your future income, you save less.

So there's a big difference between borrowing to finance, say, the Iraq War, which should not undermine the net savings rate if people take into account the government's long-run budget constraint, and the Social Security system, which directly destroys the incentive to save. It isn't generic government debt, but Social Security specifically, that poses a threat.


"A high government debt should have no effect on the dollar, as far as I can tell, if all of it were lent to Americans."\

This is at least partially true, except that it's *not* all lent to Americans. In fact, most of my discussion dealt with foreign financial institutions holding dollar securities, and I did not intend to except those issued by the US Government.

But even if this were not true, the greater debt the government carries, the less fiscal room it has to deal with shocks, thereby calming markets and dissuading financial institutions from taking destructive actions to protect itself in a crisis. Now, it's possible that the government has *plenty* of room according to economic models, but if the human beings constituting financial institutions don't think so, then the market is going to behave exactly as if the government is carrying too much debt.

re: Social security - no arguments there.


As an aside, I really don't think we want Italy's or especially Japan's economy.


Also, I would recommend taking a peek at MaxedOutMama's blog. I've been hearing some of the same things from friends working asset-backed securities in San Francisco.

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