Is There No Relation Between the Federal Deficit and the Dollar?

This started out as a comment to PGL’s post below but got so long I turned it into a post. In the comments to what PGL said (which I mostly agree with), Dean Baker says “’I’m also hard-pressed to see that his deficits played much role in keeping up the value of the dollar” . This is a question that at first took me by surprise but then I realized that I had been thinking under the presumption that there was such a relationship – and that the sign of the relationship was the opposite of what Dean was implying. So I am writing this to see if the general readership can shoot holes in my argument so I can decide what I think.

Dean Baker’s argument seems to be that a higher deficit leads to higher interest rates which should strengthen the dollar for interest parity reasons. That logic makes sense but only as much empirical sense as we can find in interest parity theories of exchange rates. My impression of these theories is that they work fine except when they don’t, so on that basis one would have to concede that Dean may be right.

But that makes it sound like it is silly to see any relation between government dissaving and national dissaving (which is what a CA deficit is) and since I certainly do believe that sustained CA deficits eventually lead to depreciation, a link between the government deficit and the CA would mean a link between government deficits and the exchange rate. While there certainly is no one to one relationship between the federal deficit and the CA deficit it seems a stretch to say there is no relationship at all. And if there IS a relationship then cutting the deficit reduces the extent to which the dollar eventually has to depreciate by reducing the quantity of dollars we emit into the world every day.

So that is why I have trouble buying the idea that there is no relationship between the deficit and the dollar.

While I hate to sound like an apologist for the IMF, it is a fundamental of stabilization that you need to quit emitting your currency if you want it to stabilize. It is simply a matter of supply and demand. If you are supplying too much of your currency then the price of it (the exchange rate) will drop unless demand keeps pace. The problem in a place like e.g. Argentina is that nobody will hold their emitted currency in the first place so there is a direct relation between running a deficit and seeing your currency tank. If a country like Argentina runs a deficit one of three things can happen:

1. They can float bonds like we do and borrow the money, seeing interest rates go up as result. This is using domestic savings to fund government dissaving.

2. They can monetize the deficit either directly by forcing the central bank to honor their worthless checks or indirectly by having the central bank buy the bonds back from the public. This is using an inflation tax to fund government dissaving and basically imposes a tax on anyone holding the currency.

3. They can sell the bonds to foreigners who can end the chain of causation if they are willing to hold on to them. This is using foreign savings to fund government dissavings.

Though a crisis can occur in a variety of ways, if the foreigners lack confidence in the government then signs of incompetent management such as large and growing fiscal deficits will often result in them dumping the bonds and/or refusing to buy new ones. This quickly throws the government back on options 1 and 2 so that they end up with higher interest rates and a monetization of any new deficit. The thinner the domestic bond market the more direct is the link between government deficits and monetization, with only the foreigners available to act as a “shock absorber”. And lots of monetization means lots of money growth, lots of inflation and lots of depreciation

We don’t see the direct relationship between deficits and monetization in the United States for two reasons:

1. We have a big domestic bond market

2. We have lots of willing foreigners who buy our paper and hold it.

So the real question in this debate is – to what extent are we becoming more like, e.g. Argentina, or to what extent do we retain the privileges that go with being the emitter of the world’s reserve currency?

Looking at the past few years it has become increasingly apparent (to me, anyway) that our own bond market has become less important as a marginal buyer of our government’s paper and foreign central banks have become more important. Of course if Ben B is right, that is because they love our country so much as a place to park their savings that they are outbidding residents for those bonds. I have trouble believing that story, probably because I spend too much time reading what Brad Setser writes – those willing foreigners are disproportionately foreign central banks who have other plausible reasons for accumulating our paper. In sum, our government dissaving is increasingly being financed through use of foreigners’ savings rather than domestic savings.

But either way we have a major problem if, as happens in non-hard currency countries, the foreigners lose confidence and stop wanting our paper. At that point we are in the same boat as Argentina and there are two things that will happen. First, they either sell or quit buying our paper, meaning that the exchange rate will fall. Second, our interest rates spike, leaving us with two outcomes – a recession together with a far higher cost of borrowing for the government (and the rest of us). At that point we will really really wish we had left ourselves with more capacity to borrow and more capacity to run a bigger deficit because we will need them badly to have a counter-cyclical fiscal policy such as Ed Prescott doesn’t believe in.

So that is my reasoning, and one of the reasons I get so wound up whenever I watch Congressional Republicans heedlessly running up huge deficits. If my reasoning is correct then the road we are on is one which leads to an end to our reserve currency status since that is the implication of the day when “foreigners lose confidence and stop wanting our paper”. It is worth repeating something I have said before – I am not predicting that this WILL happen. I think the odds are still fairly low. But the fact that the odds are big enough to talk about is shocking. And there is a lot of room before that gloom and doom disaster scenario for the effects I am talking about to have an impact.