The Fed Evokes Shakespeare

There's no shortage of reasons to worry about the health of the U.S. dollar: a still-huge trade deficit, a huge and swelling budget deficit, pervasive credit troubles, a serious recession that may linger, the threat of capital flight, etc. etc. Should we be worried about a currency crash?

That question is ambiguously phrased. It's quite possible the dollar could crash. But how bad would it be if it did? A surprising answer comes from a recent study by Federal Reserve economist Joseph E. Gagnon. The title lays out a broad hint: Currency Crashes in Industrial Countries: Much Ado About Nothing?. Gagnon's answer is basically, yeah.

Gagnon looks at 19 episodes of sharp currency depreciations-15% or more over four quarters-in 20 industrial countries since 1970. Factors that caused the crashes include inflationary policies, large current account deficits, capital outflows, and rising unemployment rates. Sometimes one factor was enough to cause the slide, sometimes it took several. But his surprising finding is that crashes were followed by poor outcomes-slow GDP growth, rising bond yields, and falling equity prices-only when inflationary policies prevailed. But the currency crash seemed not to contribute to poor outcomes-if anything, they mitigated them. The inflation did the damage, not the currency troubles.

The greatest danger from a currency crash came when the central bank was pegging a specific currency value despite inflationary policies. If the exchange rate is flexible or floating, there's considerably less trouble.

It's important to note that an inflation must be underway, and not merely expected, for a currency crash to be truly damaging. The threshold level of inflationary risk is a rate that's more than two standard deviations above the 20-country average, which works out to 7.2 percentage points.

Gagnon also finds that devaluations can successfully stimulate GDP growth and improve the foreign balance with little effect on inflation. He concludes: "Non-inflationary currency crashes uniformly had good outcomes: GDP growth was average to above average, bond yields fell, and real equity prices rose."

We're not conspiracy theorists, sad to say, but a word on what this paper might mean, aside from its interesting conclusions. There must be talk within the Fed about what would happen should the dollar fall hard-and maybe even if such a devaluation might be a good move for the U.S. Though no central banker or finance minister would ever let on that he or she is thinking this way, you can imagine the temptation. And from all this we'd conclude: avoid betting the farm on dollar strength. But if you lead a dollar-denominated life, you have little to fear from a devaluation. Things might look a little different in Beijing, but that's another story.