Default and the Dollar

Government shutdown, debt ceiling deadline just around the corner. Were you watching this show when it was first on, in the summer of 2011? People were predicting that even the possibility of a technical default (which almost happened), or credit-rating downgrade (which did happen, on Aug. 11) should lead to a sharp rise in US interest rates and a fall in the dollar. Neither of these things took place. There were some interesting discussions why not, which are worth revisiting now.

Here is something I wrote at the time:

How is it possible that a downgrade in federal debt could increase demand for it? One obvious reason is that it could increase the political pressure for austerity, making lower growth more likely, and owners of financial assets might recognize this.
But there’s another explanation, which is the that federal debt is a kind of Giffen good. This Baseline Scenario post makes one version of the argument. Here’s my version. 

Wealthholders choose their portfolio to maximize risk-adjusted return, but subject to a survival constraint such that expected probability of returns at each future time t falling below some floor is subjectively zero (less than epsilon, we can say.) The existence of this kind of floor is one of the central things that distinguishes the Minskyan view of the world. (Minsky would talk here about cashflows rather than returns, but the logic is the same.) 

Now suppose the riskiness of the portfolio increases. Then to keep the distribution of returns from crossing the floor, investors need to shift toward lower-risk assets. This is true even if the increased riskiness of the portfolio came from the lower risk assets themselves. 

Here’s another way of looking at it, more in the spirit of Holmstrom and Tirole. Making a risky/illiquid investment requires holding a greater quantity of money-like assets to ensure a zero (or less than epsilon) probability of the investment pulling you below your survival constraint. In effect, this lowers the return on the investment, since the total return has to be calculated on the cost of the asset itself plus the cushion of money-like assets you need to purchase along with it. If safe assets are less safe, you have to hold more of them to cushion the same risky asset. This means that an increase in the riskiness of safe assets implies a shift in demand toward safe assets and away from risky ones.

I also wrote this, about the appreciation of the dollar following the downgrade:

There was a very interesting piece from the BIS recently about why a fall in the price of US assets may be associated with an appreciation of the dollar. (It’s the McCauley chapter in the linked document.) They argue that many purchasers of dollar assets wanted the asset, not the foreign-exchange risk, so they hedged it by simultaneously selling the dollar forward, or otherwise issuing a dollar liability of equal value to the asset. But this means if the value of the US asset declines, they are overhedged, they now have a short position in the dollar. To get rid of that foreign-exchange risk they have to liquidate the dollar liability, which means buying dollars. 

If this sort of hedging were universal, it would have somewhat counterintuitive implications for the exchange rate. Changes in demand for dollar assets would then have no effect on the value of the dollar. And changes in the dollar value of US assets would induce opposite-signed changes in the value of the dollar. According to the BIS, this kind of hedging is very common among European investors in US assets, but not at all common among US purchasers of foreign assets — for US purchasers, the foreign-exchange risk is part of the asset, not something they want to get rid of.

I don’t see any reason to have a strong prior that hedging the forex risk cannot be common among purchasers of foreign assets. If it is common, this sort of “perverse” movement of exchange rates in response to asset-price changes is not just possible, but predictable. And if the hedging is asymmetric, as the BIS study suggests, then we would expect a global rise in asset prices to lead to a decline in the value of the dollar, and a global fall in asset prices to lead to a rise in the price of the dollar.  

Going a step beyond the BIS study, I think there’s a sociological element here. Actual portfolio choices are very seldom made by the ultimate owners, they’re made by intermediaries who are typically specialists of some kind. Now if, let’s say, European purchasers of US equities are largely made by intermediaries, who specialize in equities (domestic and foreign), then they’re going to want to hedge the forex risk — that’s not what they have the expertise to manage. Whereas if US purchases of European equities are largely made by intermediaries who specialize in European or in general foreign assets (equities and otherwise) then they are not going to want to hedge the forex risk, managing it is part of how they get their returns. And I think this question is going to depend on the specific kinds of financial institutions that have developed historically in each place, you can’t deduce it from any underlying tastes or endowments.  

But in any case I think we have to accept that it’s perfectly possible for a decline in the value of US assets to lead to a rise in the value of the dollar, even if it seems implausible at first glance.