The Striker Report

A while back, Economist Paul Krugman assessed the likelihood of a sudden, unanticipated correction in the US dollar, and found it to be quite likely.

Krugman reasoned that any decline in the value of the dollar significant enough to halt "implausible levels" of US external debt would also be significant enough to spark a sell-off among foreign investors and a "dollar plunge": "once the desired holdings of US assets have been achieved, the argument goes, capital flows into the United States will drop off sharply, leading to an abrupt decline in both the current account deficit and in the dollar."

He then examined the possibility that investors might head this eventuality off at the pass since all actors would seem to be operating with this assumption in mind. In this case "the initial shift into dollars, and hence initial capital inflows, will be damped by expectations of future depreciation", and a smooth adjustment would be achieved.

Indeed, so far, the decline in the dollar has been orderly as global investors have begun to rediscover their appetite for risk. Renowned pessimist Nouriel Roubini said the he would not expect a crash in the dollar in the short term as central bankers in Europe and Japan could be expected to keep rates low to jump start growth.

There are some reasons to believe that this condition will continue as Germany and Japan are both highly export dependent and benefit from currency weakness. Japan continues to look at mildly deflationary conditions which could put a floor beneath the yen, and a new political regime would be unlikely to rock the boat. The euro appears to be more uncertain as the EU has little tolerance for inflation; central bankers may be faced with a conundrum in their effort to balance growth with inflation.

In the US, prices are being held down by a soft labor market and the anticipation that any recovery will be anemic. But Federal spending and monetization of debt continue apace. The money supply until recently was increasing dramatically. A natural concern for lenders would be that once they open the sluice of credit, they might be repaid in a debased currency as inflation takes hold. Yet the Federal Reserve thus far shows every sign of keeping rates low.

Currently weak velocity and low expectations for economic growth appear to have prevented the quantity of money from sparking serious inflation. The natural question arises: for how long?

The answer may be determined by how US policy makers handle deficits. If creditors feel reasonably confident that payments will be made in a non-debased currency, the current arrangement could persist for quite a while. But hanging over the prospect of a dollar adjustment and a robust US recovery is the sword of higher interest rates which may become necessary to keep creditors sanguine.

The US dollar may continue to retain its special status in the near term in part because the prospect of a "dollar plunge" is sufficiently unpleasant for enough investors to move mountains to avoid it. But as in a game of musical chairs, everyone knows the music will stop sooner or later, but someone is still left without a chair.