MNI INTERVIEW:Dollar Crash Could Hit Without Warning-Cecchetti

A possible global shift away from U.S. assets brought on by President Trump's barrage of tariffs raises the spectre of a balance-of-payments crisis that could throw the American economy into recession and tip the dollar off a cliff — potentially with little warning, Stephen Cecchetti of Brandeis University and Kermit Schoenholtz of NYU Stern School of Business told MNI. 

It would be a nightmare scenario in which an abrupt reversal of capital inflows must be balanced by a current account surplus, as played out in southern Europe in the 2010s or Korea in 1998, when the won plunged 50% in a matter of weeks, domestic investment collapsed and a severe recession followed, they said in an interview.

"Since tariffs are not likely to shrink the trade deficit, which is driven by macroeconomic considerations, investors may come to fear policymakers will look for other ways to shrink the trade deficit," said Cecchetti, a former research director at the New York Fed. 

One way to do that is to impose restraints that would make U.S. assets less attractive, constricting capital inflows, he said. 

"People are reevaluating the risk premium on U.S. assets. Say they start to get wind of the proposal to forcibly convert official holdings of Treasuries to 50-year zero coupon bonds is really being discussed. The next thing they’ll do is try to run out of Treasuries — try being the key word," he said. Prices could drop instantaneously as volatility spikes. (See MNI INTERVIEW: Tariff Benefits Loom Despite Some Fallout-Miran)

"It could happen suddenly and without warning. And all it would take are more chaotic policy choices," added Schoenholtz, a former adviser to the U.S. Treasury’s Office of Financial Research and chief economist at Citigroup. "Raising doubts about free flow of capital is a Pandora's box." 

DAMAGE DONE

That the dollar has enjoyed special "exorbitant privilege" status for decades can be reversed, and the U.S. is vulnerable to that reversal in a big way, Schoenholtz said.  

The unusual combination of a simultaneous decline in the U.S. currency, bonds and stocks and rise in gold after Trump's reciprocal tariffs shock prompted the economists to examine what data could confirm the speculation that global investors are fleeing U.S. assets, or if other factors such as rising inflation expectations and the basis trade were to blame. (See MNI INTERVIEW: Trump Accelerating Dollar Decline - Eichengreen)

They found little evidence in public data – flows data come with a lag, are private or don’t exist at all – to prove a flight from U.S. assets.

"You can create a mix of explanations that might get you a falling dollar, falling bonds and stock, but when you ask which is the simplest hypothesis? It’s that global investors are losing confidence in U.S. assets," Schoenholtz said. 

The economists plotted monthly changes in the spread between the 10-year Treasury and equivalent Bunds against change in the value of the dollar relative to the euro since 1999. They found just one-sixth of 74 standout observations over the past quarter-century fell in an "anxiety zone" where the dollar depreciates despite a rise in U.S. yields versus German yields, and the change from April 1 to April 22 is the most extreme of these. (See MNI INTERVIEW: Fed Uneasy Over Optics Of Intervention-Kashyap)

Beyond concerns over fiscal sustainability, the Trump administration's abrogation of previously signed treaties and Congress's lack of response have eroded trust in America's rule of law for years to come, the economists said. 

"The damage here is very long lasting. This lives past this administration," Cecchetti said.