Derivatives: Darth Vader's Revenge Message Board

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Non-Tech : Derivatives: Darth Vader's Revenge

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To: Freedom Fighter who wrote (848)	3/25/1999 9:52:00 PM
From: Henry Volquardsen	Read Replies (1) of 2794

Wayne, In short, yes. The market is undersetimating the potential for our chronic current account deficits undermining the dollar. But the markets and the dynamics are more complex than one factor. We've had some discussion about Greenspan referring to derivatives as a zero sum game. I made refernece to Mr G being used to looking at flows from a large macro perspective. I was thinking specificly of international accounts. International accounts are definitionally a zero sum game. The US external accounts are in balance. They have to be, it is a closed system. I can hear the howls already :) Yes trade and current accounts are in deficit. But there has to be an offset. The offst is in the capital accounts. Every dollar of the current account deficit has to be held as an investment offshore. Now the traditional scenario drawn from this is the one you reference. It treats the current account deficit as the constant. The question then becomes what happens if foreign investors lose their appetite for dollars and try to exit. The answer is obvious. The dollar would decline in price as holders tried to find a price where new investors could be induced to step in. And interest rates would rise and equity prices would fall as they too found levels to attract replacement investors. The one problem with that scenario is that the trade deficit cannot exist without the investment demand. Unless there was a net demand for investment there could have been no financing for the trade deficit. Absent the investor demand the dollar would have already had to fall sufficiently to attract the investors. Look at the scenario another way. Treat the investor demand as the constant. There is evidence to support this. What would happen if the US eliminated its current account defecits? There would be no excess dollars pumped into the offshore markets. The investor demand for dollars would then bid up the dollar to a level sufficiently high to make imports cheap enough and US exports expensive enough to create a deficit large enough to satisfy the investor demand. This mechanism works for all economies, not just the US. The scenario you outlined also contains the assumption that US is an inferior investment environment. That eventually foreigners will recognize that and withdraw their money. There are some valid concerns about the health of the US economy. But currency valuation is not a yes or no vote on one particular economy. It is about relative valuation of economies against one another. The only other realistic alternatives for investing reserves and for foreign investment are Europe and Japan. No other currency is large enough to absorb the flow. On a relative basis the US comes out pretty well. Both Japan and Europe have worse debt problems. Their total debt to GDP is much larger than the US. Their budget deficits as a percentage of GDP are also larger. The US business environemt is stronger and more flexible than either. On a relative basis the US is still an attractive investment. Henry

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