The Dollar's Not That Strong

While I'm throwing darts at Paul Kedrosky, I ought to mention that I also think he's quite wrong about the dollar. He has a good line -- "think of the dollar as Squealer the Pig collectible Beanie Babies circa Christmas 1996, and you begin to get the picture" -- but he's falling prey to the classic error of looking at where the dollar's coming from, rather than where it's actually at.

For the past five years or so, the dollar has been the single largest funding currency in a global carry trade worth untold trillions of dollars. People borrowed and sold dollars, buying all manner of other currencies, from the British pound to the Brazilian real. Now that carry trade is being brutally unwound, and the world's currencies are snapping back to a much more natural level.

The European tourists in New York and the Latin American tourists in Miami all knew it. Lord knows American travellers in London and Paris knew it. The Canadians knew it, the Russians knew it, and, most of all, the Icelanders knew it, buying up shiny new SUVs at massive discounts thanks to their hugely overvalued currency. They all knew that the dollar was very weak. Now, those days are over.

To put it another way, the effect of the carry-trade unwind has been to bring the world closer to PPP than it has been in years. There's something which just feels right about emerging-market countries being cheaper than developed countries, which means that the decline in the Russian rouble and the Brazilian real doesn't shock me, even if they are running trade surpluses. And with a declining oil price bringing down the US trade deficit, a large part of the fundamental reason for dollar weakness is going away.

The go-to guy in the blogosphere when it comes to international capital flows is, always, Brad Setser:

This is much more of an unwinding of carry trades than a flight to quality -- though there is an aspect of that too. Some Russians for example, seem to have rediscovered the joy of holdings dollars rather than rubles.
The dollar's rally has a silver lining. It has pulled the RMB up too -- and the RMB needed to appreciate against most European and emerging market currencies.

Brad is no dollar bull, but even he doesn't buy the idea that the dollar is in any kind of bubble right now. And remember that for all the real economy seems to have overtaken financial-industry chaos as the prime cause of market turmoil, the financial sector is still a very long way from being out of the woods. And European banks, in general, have much more leverage than their US counterparts -- a commercial bank like Barclays is levered to the kind of degree which would make Bear Stearns blush. If leverage is the root cause of all the recent chaos, then it stands to reason that the euro would get hurt hard.

Besides, remember that the euro, when it launched* at the beginning of 2002, was worth just 88 cents. Today, it's worth $1.28. That's a substantial appreciation of the euro and depreciation of the dollar. We just took a rather circuitous route to get here from there, is all.

*Update: "Launched", here, means "launched in physical currency form". The euro existed for three years before that in electronic form, and before the euro there was the ecu, which was originally set at 1 ecu = $1.