The Meltdown Cometh?

Brad DeLong has an interesting post (Brad DeLong: Required Reading on the Dollar: directing people to Nouriel Roubini's latest paper with a colleague about the near term prospects for the dollar and the likely impacts on the global economy. The news isn't promising for those who worry that the US may be on the verge of a major economic crisis.

American's are notoriously independent. Their scorn of the United Nations stems in large part from their reluctance to let any one from another country tell them what to do. How do you think they would react to an IMF like intervention? Can anyone say Argentina?

Roubini's brief discussion of this is available at his blog.

The message in brief? America's trade deficit, combined now with the growing budget deficit, threaten the strength of the dollar. But since so much of the global economy is linked to the strength of the dollar, a precipitous decline in the US dollar could force economic downturns in other countries. And since these countries are financing our trade deficit, the decline in the dollar is eroding their investment. Hence they have pegged their currencies to the dollar in a system that resembles the fixed exchange rates of the post WWII period. But this system threatens the stability of the euro's value, making it likely that Europe will need to either enact protectionsit measures or join the dollar fixed system. But if everyone pegs their currency to the dollar, then we, by virtue of our huge deficits in public spending and trade, become beholden to them for our economic fortunes. If these countries ever abandon the pegging their currencies to the dollar, it's value will melt down.

So are they likely to stay in the system or bail? Roubini & Setser (2004) argue that the incentives for all players (nations) are to stay in the system together (meaning the US economy doesn't melt down for a generation) but that the incentives for individual nations are to bail on the system and leave the others to hold the bill (meaning that the economy melts down in a matter of years). Sooner or latter, the dollar has to collapse. The question is - who will be left holding the bag?

Roubini's summary conclusion? "The flow and stock imbalances associated with Bretton Woods Two are much larger than the imbalances created by the initial Bretton Woods regime. The scale of these imbalances and the difficulties sustaining a cooperative equilibrium in a game with strong incentives for free riding make it likely that the Asian dollar-renminbi standard will crash in years, not decades."