Martin Feldstein on the dollar

LW: Harvard economist Martin Feldstein argues that even though the US dollar is losing its status as the world's principal "reserve currency", it has a bright future as an "investment currency". The large foreign exchange holdings held by some central banks, he argues, are not reserves in the traditional sense. In reality they are investment funds, albeit "investment funds that also deter attacks by forex speculators".

“It is prudent for any country with large foreign exchange balances to diversify those funds. It is not surprising then that countries such as China and Korea are diversifying away from dollars, primarily into euros.

That diversification cuts demand for the dollar, putting pressure on its value. Market participants should see this as a natural consequence of the shift of foreign exchange balances from liquid dollar emergency reserves to longer-term multi-currency investment portfolios. But even as countries diversify away from exclusive reliance on dollars, the dollar will continue to be the main form of liquid investment for countries around the world.

As this portfolio rebalancing comes to an end, demand for dollars will stop falling. At the same time, the dollar's reduced value will shrink the US trade deficit, reducing the annual supply of dollars. This stronger demand for dollars and reduced supply can end the dollar's decline. What looks like a crisis of confidence in the dollar as a reserve currency is just part of the evolutionary process that will eventually halt the dollar's decline.”

Martin Feldstein, "The dollar's fall reflects a new role for reserves", Financial Times (10 December 2009).

http://www.ft.com/cms/s/0/0b0ad07c-e50f-11de-9a25-00144feab49a.html

Martin Feldstein (1939-) was from 1972 to 2008 President and CEO of the National Bureau of Economic Research (NBER), except for the period 1982-1984 when he was President Reagan's chief economic adviser. He is currently George F. Baker Professor of Economics at Harvard University, where he has taught for decades.

LW: Nothing can go on forever, certainly not the decline of the dollar, but I am not confident that the process of adjustment will be so easy. The implication of Feldstein's line of reasoning is that central banks will choose to invest only a small amount of their foreign exchange in US treasury bills. What will happen to US interest rates - and the cost of financing the massive US public debt - as Asian central banks dump US treasury bills? Big sums are involved. As Feldstein notes, Thailand holds foreign exchange assets of $100 billion, South Korea $200 billion, Taiwan $300 billion, and China more than $2,000 billion.

DOW: Like Larry, I am not at all confident that the adjustment process will be at all easy. The U.S. (and, indeed, many other countries, most notably, China) have for several decades built their economies on the basis of a set of exchange rates and expenditure patterns that have been and continue to be in a state of fundamental disequilibrium. During these years, patterns of production and employment and consumption and capital formation have adjusted to the prevailing network of trade relationships, including large and on-going financial inflows and outflows from one country to another that are no longer sustainable.

Rebuilding these economies -- and that is what needs to be done -- will take time and involve a large-scale reallocation of productive resources from present patterns of use as some countries expand their exports by increasing the range of products they sell on world markets and other countries shift their production toward their home markets. Employment levels and real incomes will be reduced, at least initially, as workers in some lines of production are transferred to other activities in a process of change fraught with the possibility of permanent loss of livelihood. Changes to exchange rates and terms of trade will affect every individual, and the growth of the world economy is likely to be slower during the adjustment process than it otherwise would have been.

For the U.S. and China very large changes are needed to create patterns of production and spending and exports and imports that are compatible with a rapidly growing world economy. Fortunately, in the case of the U.S. it is a very large economy with a history of great adaptability. Difficult as they may be, the U.S. is likely to weather these changes much better than smaller and less adaptable economies. In the case of China it is difficult to predict how it may fare as the process of adjustment intensifies but there certainly are reasons to believe it can succeed in restructuring its economy.

No one should underestimate the difficulty of the adjustment process that must be undertaken and its importance for the future of the world economy. A changed role for the dollar is only one of them. Feldstein mentions and Larry notes the very large sums involved on the financial side of any adjustment that might take place in portfolios. Equally large adjustments would then be required on the real side to bring about any adjustments on the financial side.

We are only at the beginning of what could be a long and difficult period of adjustment to a very changed world economy.

Thanks to Larry Willmore for the Tdj.