Wednesday, September 26, 2007

Puzzling Commentary on the Dollar's Decline

. Wednesday, September 26, 2007

Stephen S. Roach, chairman of Morgan Stanley Asia, wrote yesterday on the dollar's depreciation . "The dollar, relative to the currencies of most of America’s trading partners, is off about 20 percent from its early 2002 peak. Recently it has hit new lows against the euro and a high-flying Canadian currency." (Maybe we need to stop calling it the looney and start calling it the "goose").

I have always had a lot of respect for Roach's commentary, but two things about this particular article struck me as a bit odd:

1. Roach calls the dollar depreciation " the functional equivalent of a tax hike on consumers." Except, it isn't functionally equivalent to a tax increase. A tax increase would generate revenue that the government could spend on services (or investment). Why not instead simply call it what it really is, a reduction in real income. The fall won't be 20 percent, but it will be real.

2. Roach then asserts that a Chinese revaluation constitutes a tax increase: "{Pressuring China to revalue] would...be an egregious policy blunder ... but it would also amount to Washington taxing one of America’s major foreign lenders." Except, this isn't a tax either--if a devaluation reduces US income, doesn't a revaluation raise China's income?

I guess he is trying to say that a revaluation would reduce the yuan-denominated return on the dollar-denominated assets China currently holds. But again, that's not a tax, it's a reduction of income and a loss of wealth (the yuan value of the 1 trillion + China currently holds would also fall). But, that loss would be offset by the income gains from improved terms of trade. Hence, goods and foreign assets will cost less in real terms in the future. Moreover, I suspect that as the dollar falls the rate of return needed to attract foreign capital rises; hence, an initial negative wealth shock may well be at least partially offset by cheaper assets and higher returns.

How that all of this nets out--increased real value of wages, salary, and interest income minus the reduced nominal interest income and the wealth shock of current dollar-denominated asset holdings--is more complicated than I can figure out, but I doubt it is negative.

More broadly, I wish Roach had taken advantage of his opportunity to explain in clear and direct terms what is happening to the dollar, why it is happening, and what the consequences will be. The piece he did write does more to confuse than clarify.

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Puzzling Commentary on the Dollar's Decline
 
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