Sunday, October 26, 2008

Flight to Safety?

One of the bigger ironies of the financial crisis is that the US has troubled financial institutions, a plunging stock market and a ballooning government budget deficit and demand for our government bonds is increasing: (keep in mind that the price and yield are inversely related). And now we also see a spike in demand for our currency: (foreign currency per dollar). Even the presumably relatively safe Pound and Euro took a plunge last week: (note that the scale is opposite, so the Dollar is still appreciating). However, the Japanese Yen seems relatively immune, relative to the Dollar, which means it is also jumping in terms of other currencies: In troubled times, demand for assets deemed "safe" (or "liquid" or "quality") traditionally goes up, which is why things like emerging market debt and junk bonds often suffer, regardless of the virtues (or lack thereof) of the issuers. But it is quite remarkable that, for all that is going wrong in the US, we are still on the receiving end of this flight to safety effect.

How much of this to attribute to virtue versus good fortune is a good question for international economists and economic historians to contemplate. More immediately, despite all their prudent reserve-building since the crises of the late 1990's, emerging markets are once again getting hit hard. Dani Rodrik sees an urgent need for IMF action. See also Arvind Subramanian, Brad Setser and Naked Capitalism.

From a US standpoint, although we are better off with a flight into, rather than out of our currency and assets (which would cause a huge spike in long-term interest rates), the Dollar's rise is hardly benign. Until recently, the mostly-non-panicky drift downward of the Dollar was helping turn around the current account deficit - a sustained move in the other direction would be trouble for exporting and import-competing industries (indeed, Rodrik fears this could lead to protectionism).

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