First:; No Free Lunch
What you don't think about can't hurt
It is, of course, cruel and childish to
take pleasure in other peoples' misfortunes. And so it would be wrong to
gloat over press reports that George Soros' Quantum fund has lost a lot
of money--lost money, mind you, in a bull market that has made an awful
lot of other investors look like geniuses. See, I'm not gloating.
But, seriously, there is a story behind
this no doubt temporary reversal of fortune. Again according to press reports,
Stanley Druckenmiller, who mainly runs Quantum these days, made highly
leveraged bets that the U.S. dollar would plunge against foreign currencies.
He had reasons: after all, America is running the biggest trade deficit
in history. It must have seemed logical that this would force a dollar
devaluation. Alas, the logic was wrong, or at least premature. Instead
of falling, the dollar rose against both the Japanese yen and the euro.
And so it was Quantum that got devalued instead.
You could say that this is a case of being
hoist by one's own petard. Druckenmiller had made a seemingly strong case
that the dollar was overvalued; but as his boss' books have insisted ad
nauseam, markets are not rational and often go in the "wrong" direction.
Or was his case that strong? Yes, America is running huge trade deficits;
but so what?
Suppose that you didn't know about those
deficits. (In the 1960s, when Britain was plagued by balance-of-payments
problems, a journalist asked the Chancellor of the Exchequer why the nation
had fared so much better in the days of Queen Victoria. "Ah," he replied,
"back then, we didn't have any statistics.") What you would see is a U.S.
economy booming while others sputter; it seems likely that over the next
year the Fed will tighten the supply of dollars while its counterparts
increase the supplies of euros and yen. In other words, if you ignore the
trade statistics, everything suggests that the forces of supply and demand
will strengthen rather than weaken the dollar.
And guess what? Investors are mostly ignoring
the trade statistics. The truth is certainly out there, but nobody (except
Druckenmiller) seems interested. Back in the 1980s, record trade deficits
were front-page news; these days they tend to get a couple of inches on
page C-3. We have not quite achieved old-fashioned blissful ignorance,
but not thinking about something is almost as good as not knowing about
So are those lonely speculators who think
that the trade deficit is, as Druckenmiller put it, an "impending disaster,"
completely off base? Not entirely. In the long run, a country, like an
individual, must pay its way. America's trade deficits cannot go on forever;
and as economist Herbert Stein has famously pointed out, things that cannot
go on forever, don't. Sooner or later, foreigners will grow weary of holding
ever larger quantities of U.S. assets; that is, they will no longer be
willing to invest enough to finance both the continuing trade deficit and
the growing interest payments on America's foreign debt. When that happens,
the dollar will fall--and the longer that day is postponed, the bigger
Now, you might ask why a short-term speculative
institution like Quantum should be interested in the long run. The answer
goes like this: If investors correctly understood how much the dollar will
have to fall in the future, they would be selling dollars now--unless they
were compensated for that risk by higher interest rates. And while interest
rates in the U.S. are higher than those in Europe or Japan, the premium
is probably too small to make dollar investments a good bet given the size
of our deficits. So there's a pretty good case that markets are overpricing
the dollar, that one of these days they will realize their mistake, and
that on that day the dollar will plunge (and Druckenmiller will look smart
again). This kind of reasoning sometimes works; in fact, once upon a time
it even worked for me, when I used "sustainability" analysis to predict
a dollar crash in 1985.
But I am still puzzled about why Quantum
made such a big bet on the overvaluation of the dollar (and why some journalists
seem to have been talking up the prospect of a dollar crash). You see,
this sort of argument--based on long-run considerations, the price is too
high, and eventually the market is going to come to its senses--is also
used by people who claim that U.S. stock prices are way too high. And if
you ask me, the arithmetic on future earnings is worse than that on future
trade deficits. In fact, on my personal list of economic things to worry
about, the U.S. trade deficit doesn't even rank in the top ten. So why
not short the Dow, instead of the dollar? Stock market bears have been
wrong year after year, but one of these days... Oh, never mind.
PAUL KRUGMAN is a professor of economics
at the Massachusetts Institute of Technology and the author of The Return
of Depression Economics.