April 12, 2011
The Washington Post had a piece on the reaction of financial markets to the debate over the budget. It included a comment from William Gross, the manager of the Pimco bond fund, complaining that if the United States did not reform entitlements then a default is inevitable. He then said that the default would take place through “inflation, currency devaluation and low-to-negative real interest rates.”
This sort of “default” probably does not sound too bad to the overwhelming majority of the public who do not hold large amounts of government debt. More importantly, the devaluation of the currency is essential if the United States is to stop being a huge net borrower from other countries.
Changes in the currency value are the main mechanism for adjusting trade balances in a system of floating exchange rates. If the dollar is over-valued by 20 percent then this has roughly the same effect as subsidizing our imports by 20 percent and placing a tariff of 20 percent on all our exports. The over-valued dollar has far more impact on our trade balance than all of our trade deals put together.
If the value of the dollar does not fall substantially, then the United States will continue to run large trade deficits. This logically implies that we will have negative domestic savings (i.e. it is an accounting identity, there is no way around it). Low private savings means either large budget deficits or very low private savings or some combination.
In other words, if Mr. Gross does not want the dollar to fall, then he either wants to see large budget deficits and/or very low private savings. Or alternatively, he doesn’t understand basic economics.
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