Dollar crashes, interest rates fall?

Alan Greenspan's legacy may hinge on whether that headline is written, or whether the headline reads: "Dollar crashes, interest rates surge."

From Reuters:

Although a dollar crash is unlikely anytime soon, a Federal Reserve study says any collapse in the value of the currency is unlikely to hurt the U.S.  Instead, many economists suggest an abrupt decline in the dollar's value would cause pandemonium in both U.S. economy. But few analysts agree. credit and equity markets.

To maintain foreign interest in U.S. financial markets and prevent large investment outflows, which would disrupt the economy, the central bank would begin raising short-term rates aggressively, analysts say.

But rising short-term rates alone would choke U.S. economic growth as American consumers would be inclined both to save more and borrow less. Since the United States buys goods from around the globe, analysts emphasize the spillover would be worldwide. .... 

The Fed though, is at odds with the thinking on the street, according to its recent report.

"Currency crashes do not generally lead to higher bond yields in industrial countries," the study said. "Indeed, over the past 20 years, currency crashes in industrial countries have always been followed by falling bond yields."

While Joseph Gagnon, assistant director of the Fed's Division of International Finance, notes in the study that currency crashes in the 1990s in Mexico and East Asia did push long-term rates up to debilitating levels, he added that rich countries appear better able to deal with the threat because of the inflation-fighting credibility of their central banks.

Gagnon found the change in bond yields after a currency crash was strongly linked to the level and change in inflation after the crash.

The U.S. experience since 1970 has been limited to just one dollar crash, in 1985-86, Gagnon said. In that time, the U.S bond yield dropped more than 4 percentage points, counter to what Wall Street would anticipate.

Check out Gagnon's paper.    The Fed is not alone - a couple of months ago, a well-known bond fund manager was making a similar bet, or at least betting that he could get out of US bonds before Asia gets out of the Bretton Woods 2 system than props up both the dollar and the price of dollar-denominated bonds.

Few debates are likely to be more important.   At some point - though it is hard to know when - the dollar will fall.   That is what happens to the currencies of countries with large trade deficits.   The interest rate path most likely to accompany that the dollar's decline, though, is far from clear.

Greenspan - in some sense - is betting big on a relatively benign adjustment.  The fabled soft landing.  

He, after all, has stood by even as the US current account deficit has reached record levels, arguing that financial globalization has reduced the risks associated with a more leveraged US external position, and neither large US trade deficits nor a rising debt to GDP ratio is a particular concern so long as the US economy stays nimble.   But no country's debt can increase indefinitely, even if many of your creditors are seemingly generous foreign central banks.   Greenspan expects housing prices to stall, making it more difficult for Americans to borrow against their home -- and bringing down consumption, imports and the current account deficit.   Paul Krugman is not convinced; he thinks the end of the housing bubble will only lead to significant improvement in the trade balance if the dollar deflates along with housing prices.

Greenspan is betting that the US economy can reorient itself back towards export production relatively easily, without any hangover from the recent housing splurge.  He also is betting the global financial system can manage the associated shifts in key financial prices smoothly.   Neither is a sure thing. 

7% of GDP current account deficits are not the typical legacy of a successful tenure as central bank governor.  But Greenspan is not your typical central banker.  Still, I would want to wait and see how Greenspan's bets play out before declaring him the greatest central banker who ever lived.