Tossing A Coin

During the next two days, Chairman Greenspan will be testifying before congress. The global economy will be intent on his remarks. In the meantime, I report here on his Frankfurt panel discussion from November 19, 2004, which he mentioned in his recent London remarks.

Perhaps the most sensible observation he makes is not one I would like to hear. "Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that, of the thousands who try, some are quite successful. So are winners of coin tossing contests."

This is confirmed by my own experience trading currencies over the years, and yet. . . the game goes on.

In the November speech, Greenspan takes what seems to me an unusual step and emphasizes that "I speak for myself and not necessarily for the Federal Reserve." He also refers to a paper by Caroline L. Freund. The type of document is an International Finance Discussion Paper, "circulated to stimulate discussion and critical comment." Caroline Freund is an economist in the International Finance Division of the Federal Reserve Board. She emphasizes that the views presented are solely her responsibility and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.

The International Finance Discussion Paper, Number 692, is dated December 2000, and is called Current Account Adjustment In Industrialized Countries. In it she presents 25 examples of large current account adjustments which have occurred since 1980. (Including the United States in 1987). The typical current account reversal begins when the current account deficit as about 5 percent of GDP, that it is associated with slowing income growth and a significant real depreciation over a period of about three years. The short-term interest rate displays a hump-shaped pattern, it is elevated by about 2 percent in the year the current account bottomed out.

The conditions facing the U.S. are similar to those seen before. The current account deficit is now more than 5 percent of GDP. Short term interest rates are expected to ramp up by around 2 percent this year. The dollar may weaken over the next three years to bring the deficit under control. Conceivably the economy could be headed toward slower growth in the next three years.

What is not mentioned specifically is the trade imbalance with China. The current arrangement between the U.S. and China is a fixed exchange rate. This does not allow the current account to adjust in the normal way. China must revalue its currency. They will drag their feet as long as they can. But change must come.