06/21/1999 
Fortune Magazine 
Time Inc.
Page 36+ 
(Copyright 1999)

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 it. 

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 the fall. 

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.