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The Dollar : Medium and Long
Term Prospects
Michael Dooley
XXI Meeting of the Latin American Network of Central Banks
and Finance Ministries
May 13, 2005
Standard View
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Current Account Deficit at 6% of GDP
Normal upward pressure on the euro and
other floaters
Undervaluation of Fixed Asian
Currencies
Excessively high asset prices
Asia overheating; adjustment through
inflation.
If it goes on, it will end badly
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Currency crises.
Large dollar depreciation.
Banking crises.
Rapid rise in US yields.
Sharp recessions.
Meanwhile Europe and Latin floaters
do badly.
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Private sector capital less willing to
move to US.
So exchange rate rises, cutting net
exports and pressing goods markets.
The high euro and other floating
currencies is here to stay.
If floaters cannot generate internal
demand, they face economic stagnation.
External pressure to appreciate
Asian currencies

Protectionist jargon: burden sharing,
currency manipulation,
undervaluation, beggar-thy-neighbor.
How patient can we afford to be?
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Five years is a long time for our
basic macro- models to be so far offtrack on the most important macro
phenomenon of the era.
Depression and halfway into the
New Deal.
What drives the US current account
deficit?
10-year TIPS Yield
US Current Account Balance
%
% of GDP, saar
4.5
0.0
Obstfeld-Rogoff I
4.0
-1.0
3.5
-2.0
3.0
-3.0
2.5
-4.0
2.0
-5.0
1.5
-6.0
1.0
Jan-99
-7.0
Jan-00
Jan-01
Source: Bloomberg, Haver
Jan-02
Jan-03
Jan-04
Jan-05
Q1-99
Q1-00
Q1-01
Q1-02
Q1-03
Q1-04
US Demand for Foreign Savings
Real Interest
US Demand
Rate
r
US Demand for
CA
Source: GMR
Foreign Savings
Equilibrium current account and real rate,
private supply only
Real Interest
Rate
US Demand
r
Private Sector
Supply
CA
Source: GMR
US Demand for
Foreign Savings
Looser fiscal policy raises real rate
and CA deficit
With Looser
Real Interest
Fiscal Policy
Rate
US Demand
r
Private Sector
Supply
CA
Source: GMR
US Demand for
Foreign Savings
Equilibrium current account and real
rate, private supply only
Real Interest
Rate
US Demand
r
Private Sector
Supply
CA
Source: GMR
US Demand for
Foreign Savings
Push in from official sector lowers real
rate, raises CA deficit
Real Interest
Rate
US Demand
Official
Sector
Supply
Pre-intervention
Equilibrium
Official plus
Private Sector
Supply
US Demand for
Foreign Savings
Source: GMR
The international monetary system
adapts to economic problems.

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Bretton Woods was an explicit
compromise between the US and UK
to solve the perceived problems of
the depression and WW2.
The current ad hoc system exists
temporarily to solve the problem of
the emergence of Asia.
Revived Bretton Woods System
It is now generally accepted that the
broad outlines of the current
international monetary system are
as we described them two years
ago, and subsequently labeled “the
Revived Bretton Woods system”. In
summary, these features are:
Revived Bretton Woods System

the emergence of a macroeconomically important group of
countries with currencies managed
vis a vis the dollar to support exportdriven growth;
Revived Bretton Woods System

the US as center and reserve
currency country providing financial
intermediation services for Asian
savings.
Revived Bretton Woods System
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poorer economies export large
amounts of capital to richer
economies, in fact, almost entirely to
the US;
unusually low and even falling short
and long term real interest rates as a
result of this glut of global savings.
Revived Bretton Woods System
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Not agreed and under vigorous
discussion are:
How long will this system last?
Will it be a meteoric flash with a
spectacular end soon to come?
Or will it last for the reasonably
foreseeable future?
Will it last? What drives the
system?
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The key economic problem of our
time:
To manage the economic emergence
of China.
Employ 200 million underemployed
workers.
The political economy tradeoffs
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China chooses an export driven
development strategy.
It wants to move workers into
industrial sector rapidly but faces
increasing costs.
It has a domestic financial system
that is a capital destroyer.
The political economy tradeoffs
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At the end of the game, it wants a
viable capital stock.
This leads to a clash with trading
partners.
Failure to deal with these two
distortions blocks development.
Solution:
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Set real exchange rate so that initial real
wage generates surplus for capital,
including FDI.
Large initial stock of labor implies low
initial real wage, but rising through time.
Large initial stock implies long
adjustment period.
Solution:
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Adjustment may come from slowly
rising exchange rate or domestic wage
and price inflation or both.
Direct investors use part of the surplus to
keep import market open.
Imbalance in risks requires a net capital
outflow.
Can a desired real exchange rate path
be maintained?
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Effective capital controls.
Trade surplus must be sterilized.
Domestic financial repression.
The rest of Asia manages
exchange rates in synch.
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China is their assembly center for now
Letting go their exchange rates prices
them out vs. competitors.
China’s exchange rate policy is theirs
also.
China’s surplus with the US is adds to
Asia’s as well.
Threats to this system from its
internal dynamics?
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Costs of carry.
Reserve diversification.
Overheating.
Reserve Diversification
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Claim: small central banks will be
first movers in this game and sell
dollars for euros.
First order effect: appreciates euro,
more pressure on Euroland.
Reserve Diversification
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Note there is no one guaranteeing
the USD-EUR exchange rate here.
Huge attention paid to any hint of
shift in reserve management
policies.
Cost of Carry
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None in Japan
China stuffs its banks with paper at
3%. Depositors will pay the cost.
Others are seeking added basis
points by diversifying into higher
yielding USD assets.
Overheating?
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Experts have been predicting
inflation for years
Inflation in China falling below US
now.
Still has wide scope for sterilization.
Where is the beef?
China CPI
% yoy
30
CPI
Non-food CPI
25
20
15
10
5
0
-5
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Jan-04
China: Money supply growth
% yoy,3mma
M2
M1
24
22
20
18
16
14
12
10
Mar-98
Mar-00
Mar-02
Mar-04
China: Real 1-yr deposit rate
%
10
5
0
-5
-10
-15
-20
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Jan-04
Small Adjustment in FX Regime is a
continuation of the system.
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Small adjustment of exchange regime:
e.g. widening of bands, move to
basket—amounting to 3% p.a.
appreciation.
But real exchange rate will remain
managed and undervalued.
Large interventions will still occur.
External threats to BW2?
Rising Protectionism
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Not a serious issue in US election.
But now US seems to be pressing
hard with Senate amendment,
Treasury calls for more rapid
adjustment of exchange policy, EU
textile investigation.
Geopolitical Bump
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Problems with Japan: new US-Japan
security pact, scramble for energy
resources.
with N. Korea: always heading for a
showdown.
Problem with Taiwan: missile buildup,
increasing threat to US fleet.
Geopolitical Bump
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General military expansion.
Ringing of China with alliances: Japan,
Taiwan, Vietnam, Central Asia,
competition for India.
Reactions to potential end to EU arms
embargo.
BW1 and BW2
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Important difference may be oil.
Lots to go around in BW1.
Could be a problem for BW2.
China a potential economic as well as
military threat.
Summary: The current global monetary
system.
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Asia fixes exchange rates at
“undervalued” levels.
Especially against industrial center
country with more flexible labor
market.
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Other industrial countries and some
emerging market countries float,
appreciate.
Generates export growth and current
account surpluses.
Development strategy is to lend to
rich countries.
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Encourages large scale FDI to assure
quality of goods, capital, and to secure
export markets.
Intervenes heavily in fx reserves to
channel domestic saving through foreign
balance sheets.
Gradually lets real exchange rate
appreciate, either through inflation or
controlled nominal appreciation.