What dilemma?

The Financial Times is a very respected newspaper, so I guess there must be some logic to this column.  But I confess I have no idea what this Belgian professor is talking about.  First prize to someone that can explain this to me.

The dilemma for the US authorities now pops up in the following way. The US monetary authorities pursue a policy aimed at keeping inflation low. It’s not an explicit inflation target as in the case of the UK or the eurozone, but it is certainly an implicit one. This implicit inflation target is close to two per cent which implies that when the Federal Reserve issues dollars it gives an implicit promise that these dollars will buy a basket of US goods and services which is approximately constant (ie declines by only two per cent per year). Given that the US economy grows on average at a rate of close to three per cent per year, this implies that the yearly increase in the supply of dollars should be close to five per cent (two per cent inflation plus three per cent economic growth).

This price stability commitment however conflicts with the international role of the dollar. The worldwide demand for dollars increases at yearly rates that by far exceed the five per cent money supply growth rate that will keep prices in the US approximately stable.

Thus the US monetary authorities have to choose between a policy that accommodates for the high demand for dollars in the world, but then the supply of dollars will increase much faster than the one that will keep approximate price stability in the US. Alternatively, the US sticks to the inflation target, but this requires limiting the supply of dollars to a much lower level, frustrating the high demand for dollars worldwide.

If foreign demand for dollars is rising faster than US demand, doesn’t that mean that the Fed can increase the world supply of dollars at faster that 5% rate and still hit its target.  So what is the “dilemma?”

Even worse, if the Fed didn’t respond by increasing the supply of dollars by more than 5% a year, I still don’t see a problem.  Foreigners would still be free to accumulate all the dollars they wished, it would just mean that the dollar would tend to appreciate in nominal terms (but not real terms) over time.  So what’s the dilemma?

HT:  Marcus



12 Responses to “What dilemma?”

  1. Gravatar of Jon Jon
    14. November 2009 at 08:10

    I don’t understand his claim either.

    Here is my guess: foreign use of dollars is unstable because it lacks the force of law.

  2. Gravatar of marcus nunes marcus nunes
    14. November 2009 at 09:21

    Over the decades world demand for dollars has been increasing. Just think of all the countries that at one time or another adopted different versions of a currency board (in addition to the growth in demand by all the drug lords and assorted criminals of this world). That´s the reason behind the secular nominal appreciation of the dollar relative to a broad basket of currencies. And certainly this dollar demand was growing continuouly through the period of the Great Moderation, even more so after the asian crisis in 1997.

  3. Gravatar of Scott Sumner Scott Sumner
    14. November 2009 at 10:19

    Jon, That may be so, but it can’t be what he was thinking, as he claimed we could predict that foreign demand for dollars would increase faster than domestic demand.

    marcus, I agree that foreign demand for dollars is increasing, I just don’t see the dilemma.

    And you are right, more demand for dollars would cause the dollar to appreciate, not depreciate (as he claims.) It is a very weird piece, I can’t make any sense out of it at all. It’s not so much that I disagree with him–I have no idea why he is even making the arguments he makes. It seems completely illogical.

  4. Gravatar of jsalvatier jsalvatier
    14. November 2009 at 11:18

    I agree, this is rather baffling.

  5. Gravatar of Mario Mario
    14. November 2009 at 11:22

    I think the piece only makes sense if you make an implicit assumption that all of the dollars sent out to satisfy foreign demand end up in the US market anyway. Of course, since that should mean increased US exports or increased foreign investment (and, naturally, would trigger a change in the Fed’s policy), I’m not sure I see what the problem would be. In any event, that’s not the case.

    This last line has to be the worst though: “It is a reasonable bet because the massive supply of dollars is also an extremely attractive privilege for the US authorities which allows them to finance budget deficits at conditions that no other countries can obtain. But this choice also means that the US dollar will continue its secular decline relative to the major currencies in the world.”

    Yes, the dollar is so popular that its price will drop like a stone. Ugh.

  6. Gravatar of StatsGuy StatsGuy
    14. November 2009 at 12:17

    Well, he’s mangling a perfectly good point, which I made here:


    If you get rid of the very last sentence, the argument _would_ have _almost_ made sense about 12 years ago…

    But you have to modify this statement: “The worldwide demand for dollars increases at yearly rates that by far exceed the five per cent money supply growth rate that will keep prices in the US approximately stable…”

    to account for the price-stabilizing effects of cheap imports.

    At that time (late 90s), the US maintained a low domestic inflation rate even as the dollar increased in value BECAUSE other countries/central banks were building up dollar currency base/reserves. This created an overvalued dollar as we exported dollars to satiate demand (which harmed US exports), and we avoided inflation by importing cheap products. BTW, I mean overvalued relative to the equillibrium that would have prevailed if there was no net accumulation of the reserve currency by others.

    But long run equillibrium always comes back… Since ~2001, the dollar has been falling in value AND in share of reserves(perhaps because other countries have seen the US trade/fiscal deficits as unsustainable).


    The Euro is beginning to displace the dollar, although countries are also building up gold reserves. Almost certainly, the world market will eventually overshoot. Meanwhile, it will suck to be Europe in a decade… the overvalued Euro will blow a hole in their trade deficit while they sustain excess consumption, and then we’ll have a bout of Euro devaluation.

  7. Gravatar of ssumner ssumner
    14. November 2009 at 12:48

    jsalvatier, Thanks

    Mario, Even that assumption wouldn’t save his argument. The US can continue targeting inflation at 2%. If it does so, it will provide enough dollars to meet US and foreign demand.

    Statsguy, I see no relationship between his comment and yours. You are talking about the current account deficit, the tendency of China and Japan to accumulate lots of T-securities. In contrast, he is talking about dollars, the monetary base, which is produced by the Fed not the Treasury. He is saying that if the Fed produces just enough base money to create 5% NGDP growth then there won’t be enough for foreigners. Then he assumes that 5% growth in the base would create 5% NGDP growth. But if foreign demand really was rising at more that 5% per year, then the Fed would have to increase the base faster than 5% a year to hit its inflation target. His argument would be no different from someone saying the Fed couldn’t hit its inflation target if Colombian drug lords started hoarding lots of cash.

    His article is wrong on so many levels one hardly knows where to begin. Tight money doesn’t create “shortages” of money, it causes changes in the price level and or the exchange rate. His piece seems completely divorced from the most basic elements of monetary economics. I can’t make any sense of it at all. If if you grant him the benefit of every doubt, and allow for one or two errors, the article still makes no sense.

  8. Gravatar of StatsGuy StatsGuy
    14. November 2009 at 13:56

    Actually, I don’t think he’s differentiating between dollars (base money) and t-bills… later in the article he writes:

    “second way out of the dilemma is for the US to stick to price stability and to dramatically reduce the supply of dollars (including US treasury securities) to the rest of the world”

    The simply weird thing is how he gets to the notion that if the US supplies world demand with dollars we get inflation… Maybe he’s just mangling supply and demand. If the world _demands_ dollars (or US debt), then by definition we _don’t_ get inflation. (My worry is that eventually they might stop buying dollars/debt with their goods, and then what do we sell them to finance our structurally import-dependent economy?)

    It’s only when we supply dollars they _don’t_ want that we get inflation. (In other words, if we find ourselves in a global depression and we try to force-feed dollars into the system with other central banks taking an anti-inflation policy and rejecting dollars… like, um, the ECB… THEN the US is faced with a tradeoff between inflation and sustaining global NGDP… But only because the ECB is crazy and/or wants to topple the Dollar as reserve currency.)

    Later in the article he also marshalls a weird argument that this problem was responsible for the Dollar devaluation from 1960 through 2008 vs. the Yen/Mark. Uh… _maybe_ the reason the Mark and Yen revalued against the Dollar was because as late as 1950, their economies were still obliterated, and their economies _grew faster_ to catch up? Given that, the SURPRISING thing was that if you compare 1960 to 1998 (before Dubya wrecked the place), that the Dollar had lost so _little_ value.

    He also cites the swiss franc as increasing in value… which is odd, because for its size, Switzerland provides way more of the world’s reserve currency than it should – so it’s an exact counterpoint of what he (seems) to be arguing.

    Anyway, I tried – obviously no first prize. I will go sulk in the corner.

  9. Gravatar of Jon Jon
    14. November 2009 at 16:35

    Isn’t the build up of currency holdings endemic to the last decade? The short version is one of gold reserves followed by no reserves (faith in the IMF) followed by massive dollarization.

    The financial press gets a lot of things surprisingly wrong. For instance Fridays wsj had two articles with no references between them: one about asian cb intervention to support the dollar and one about how treasury auctions remain well subscribed by asian cb. The latter reported as very mysterious…

  10. Gravatar of Doc Merlin Doc Merlin
    14. November 2009 at 22:16

    @ Mario
    “Yes, the dollar is so popular that its price will drop like a stone.”

    Um, it already has. Look at the USDX index over the last 10 years. Relative to most of the world, the US has been following a very expansive monetary policy this decade. It shot up in oct08-april09, but has since resumed its steady downward trend. Its interesting to se GLD (the GOLD ETF) also dropped during that time, but the GLD drop started before the USDX increase.

    This is a slightly off topic side note:
    Anyway, I don’t think devaluation and relative monetary expansion works to stimulate your economy. Commodity import prices just rise to match so nominal costs go up regardless any wage stickiness.

    This plot explains it. Note the USDollars to 1 euro rate goes up at the same time as the Japanese Yen to 1 USD goes down. (Meaning the USD has weakened in value.) Despite the USD weakening through the years before the recession, and in the first few months of the recession we still have a horrible recession. I am still convinced the problem was structural and regulatory, not based on insufficient monetary expansion.

  11. Gravatar of Doc Merlin Doc Merlin
    14. November 2009 at 22:16

    hrm, the img tag didn’t work. Here is the plot


  12. Gravatar of Scott Sumner Scott Sumner
    15. November 2009 at 08:10

    Statsguy, I liked this comment much better than your first attempt to help him. You nailed every single point, and even got him on some I missed.

    Jon, Good point. International monetary econ is tricky for journalists, as it involves trade flows and broader macro issues. Journalists aren’t good at seeing things in broad “general equilibrium” terms.

    Doc Merlin, There is an identification problem here. Usually the dollar goes up and down with the strength of the economy (from supply side factors.) Thus it was strong during the tech boom. When you have a fall in the dollar that is due to monetary ease, like the 1933 devaluation, it does boost real growth in the short run despite higher commodity prices. But it is often hard to disentangle all of these effects.

Leave a Reply