Guardian UK: Dollar denial

[marmar]

Dollar denial
In the face of the dollar's ongoing fall, policymakers have seemed paralysed as they believe that either nothing should or can be done
Roman Frydman and Michael D Goldberg



"Dollar denial", that state of willful blindness in which bankers and central bankers claim not to be worried about America's falling currency, seems to be ending. Now even the European Central Bank governor Jean Claude Trichet has joined the chorus of concern.

When the euro was launched, the US dollar-euro exchange rate stood at $1.16/€1. At that price, the dollar was undervalued by roughly 10% relative to its purchasing power parity (PPP). Initially, the dollar's price rose, but since 2002, it has, for the most part, fallen steadily. Every day seems to bring a new low against the euro.

In the face of the dollar's ongoing fall, policymakers have seemed paralysed. The reasons for inaction are many, but it is difficult to avoid the impression that they are related to the current state of academic theorising about exchange rates.

Simply put, economists believe either that nothing should be done or that nothing can be done. Their so-called "rational expectations models" predict that exchange rates should not deviate from parity in any lasting way. Believing that they have found a way to model how currency traders think, they see no need for intervention because, save for temporary deviations, markets always get currency values right.

"Behavioural economists", by contrast, acknowledge that currencies can depart from parity for a long period. But they attribute this to market psychology and irrational trading, not to the attempts of currency traders to interpret changing macroeconomic fundamentals. This implies that intervention is not only unnecessary; it is ineffective: Faced with wide swings and trading volumes of $2 trillion per day, central banks are helpless to counteract traders' irrational zeal.

But both the "rational expectations" and the "behavioural" models are flawed, because they seek to generate exact predictions of human behaviour. Both disregard the fact that rationality depends as much on individuals' imperfect understandings of history and society as on their motivation.

If we place "imperfect knowledge" at the heart of economic analysis, the implications of our limited ability to predict market outcomes becomes clear. When it comes to currency markets, parity levels based on international trade are merely one of many factors that traders consider. In attempting to cope with imperfect knowledge, they are not irrational when they pay attention to other macroeconomic fundamentals and thereby bid an exchange rate away from its parity level. .....(more)

The complete piece is at: http://commentisfree.guardian.co.uk/roman_frydman_and_michael_d_goldberg/2007/11/dollar_denial.html

[kickysnana]

1. Ahhh... the think method of currency value ala "Music Man". Reality has no place here. n/t