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answer is the United States. Because the United States can create an infi-
nite supply of dollars, it is impossible for it to default.
Many other countries, including Argentina, promise to repay in a cur-
rency they don™t control (usually U.S. dollars). When Argentina needs to
come up with U.S. dollars to repay a loan, Argentina has to trade some-
thing valuable in order to get those dollars. In contrast, the United States
has the ability to make U.S. dollars for nothing (both by actually printing
banknotes and by electronic entries in the Federal Reserve system).
In some respects, therefore, the United States is the best possible
debtor. No lender need fear a default. U.S. creditors can be absolutely
certain to get back every penny of the $3.5 trillion in loans. Because
130 The Old Art of Macroeconomics



dollars can be created by the United States at no cost, the same would be
true if the U.S. debt totaled $35 trillion or $350 trillion. So we still
haven™t figured out why anyone would be worried about the United
States™ debt to the world.
In an early scene in Waterworld, Kevin Costner enters a community in
search of trade. Costner offers to sell some dirt, a precious resource to a
floating world that needs to grow plants. In return for his dirt, Costner is
offered money and after some haggling, a deal is reached. When he goes
to buy something with his money, however, Costner is angered to find
that the amount that he has just earned is too little to buy anything useful.
Hey, I™ll give you 16 quadtrillion “credits” for your car. Is that a good
price? Obviously it depends on what real goods you can buy with a
credit. Costner™s behavior makes no sense. Haggling over price only
makes sense if the money has known value. Similarly, the people who
have lent the United States money do not need to fear default. They will
get whatever amount of dollars they are owed.
The real value of those dollars, however, is very much in doubt. As we
discussed regarding inflation, the U.S. Federal Reserve determines the
value of the U.S. dollar. The larger the total debt, the more incentive there
is for the Federal Reserve to create money to erase those debts. Even
though $3.5 trillion is a small debt for the United States, creditors have
reason to fear getting repaid the full value of their debts.



Where Do We Stand in the
Cycle of Irrationality?

What is fair value for the U.S. dollar? In the long run, countries can be
neither borrowers nor lenders. Because the United States has accumu-
lated a massive debt that will be repaid, the United States will need to run
many years of current account surpluses. This change from current
account deficit to surplus will be accompanied by a fall in the value of the
dollar. Let™s look at some major currencies in detail. Figure 6.3 shows
that the dollar has already lost a lot of value against the euro.
Deficits and Dollars 131




1.30

1.20
Value of the $ in Euros




1.10

1.00

0.90

0.80

0.70

0.60
Jul-00




Jul-01




Jul-02




Jul-03




Jul-04
Jan-00




Jan-01




Jan-02




Jan-03




Jan-04
FIGURE 6.3 The Dollar Has Lost One-Third of Its Value against the Euro
Source: Federal Reserve



The dollar looks to have hit an overvalued high in late 2000 and 2001.
The dollar rose in value almost every day for years, and the airwaves
were filled with negative comments on the euro. On October 17, 2000,
Tony Norfield, currency analyst with ABN Amro said, “It is simply
ridiculous for people to keep suggesting the euro is fundamentally
undervalued. It isn™t.” At the same time, Jane Foley of Barclays Capital
went on record with: “It is still the case that Europe needs to implement
structural reforms more quickly. Until that happens and productivity
improves, investors will still want to be in dollars.”12
As is so often the case in mean markets, you™ll note from Figure 6.3
that these experts were exactly wrong. In contrast with Mr. Norfield™s
opinion, the euro was fundamentally undervalued, and even though
Europe hasn™t implemented structural reforms, Ms. Foley was wrong in
predicting that investors would still want to be in dollars.
Obviously the dollar was overvalued against the euro in 2000. Since
then, the dollar has lost one-third of its value in euros. Is that enough?
If markets were rational we might expect the decline to end when the
price of products in the United States equaled those in the euro area.
132 The Old Art of Macroeconomics



The Economist magazine, for example, calculates the average cost of a
Big Mac hamburger in the United States to be $2.90, and the cost in the
euro area to be $3.28.13
Since everyone prefers to buy Big Macs for $2.90 instead of $3.28, the
theory of purchasing power parity (PPP) suggests that prices in different
countries are pushed closer together. In the case of Big Macs, the dollar
would have to rise in value against the euro to equalize the two prices.
Thus, this burger application of PPP is saying that the dollar has fallen
enough against the euro. If the Big Mac prices were indicative of all
prices, particularly of goods that are actively traded, then the dollar does
not need to decline any more.
So the dollar might be close to fair value against the euro (there are, of
course, far more comprehensive analyses of PPP beyond Big Macs).
What other currencies are particularly relevant to reducing the U.S. cur-
rent account deficit? Figure 6.4 shows that the dollar has lost about one-
quarter of its value against a basket of major currencies.
Value of $ versus 'major currencies'




120

110

100

90

80

70

60
Jul-00




Jul-01




Jul-02




Jul-03




Jul-04
Jan-00




Jan-01




Jan-02




Jan-03




Jan-04




FIGURE 6.4 The Dollar Has Lost One-Quarter of Its Value against
Major Currencies
Source: Federal Reserve
Deficits and Dollars 133



The Japanese and Chinese economies are so large that their currencies
deserve special attention. The Chinese currency is fixed to the U.S. dol-
lar by Chinese government mandate. China runs a significant current
account surplus. There is speculation (both whispered and in the futures™
prices) the dollar will eventually weaken against the Chinese currency
(known as yuan, it is officially called renminbi or RMB).
The large current account surplus of China suggests that the dollar will
fall in comparison to the yuan. What about the Japanese yen? In 1980, I
saw a talk by Douglas Fraser, then president of United Auto Workers.
Fraser said that the reason Japanese cars sold well in the United States
was because the dollar was too strong against the yen. At the time, you
could buy more than 250 yen for one U.S. dollar. If only the dollar would
weaken to about 200 yen, Mr. Fraser suggested, American-made cars
would be a better value than those made in Japan.
The U.S. dollar soon weakened to far beyond Mr. Fraser™s target and
currently fetches about 110 yen. In spite of this weakening of the dollar,
Japanese cars and other products remain so cheap that Japan runs a large
current account surplus with the United States. Thus, the expectation is
that the U.S. dollar will continue to weaken against the yen.
Furthermore, both the Japanese and Chinese currencies are kept at
artificially low levels by their governments. Because such government
interventions always fail in the long run, these currencies are likely to
rise to their correct levels over time. The Bank of England attempted to
keep the British pound at artificial levels in 1992. Speculator George
Soros earned a reported $1.1 billion by betting that the Bank of England
could not maintain artificial levels”he was right. So the dollar is likely
to fall against the Japanese yen and the Chinese yuan.
Putting these facts together, I conclude that the decline in the dollar
that began in 2001 is not over.
The U.S. current account deficit remains near its historical high. Fur-
thermore, sentiment toward the dollar is not negative enough for a mar-
ket bottom. Recall that at market extremes, our lizard brains tend to be
exactly out of sync. Even if rational financial calculations suggest that
134 The Old Art of Macroeconomics



the dollar™s decline is over against some important currencies, mean mar-
kets don™t stop at fair value. Just as the dollar became wildly overvalued
before it stopped rising, the science of irrationality suggests that it will

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