The dollar issue.

• Author: Smick, David M.
• Position: FROM THE FOUNDER - Editorial

For more than a quarter-century, I have enjoyed a front row seat observing the world's most senior policymakers and financial traders grapple with the foreign exchange markets. At one point when he was chairman of the Federal Reserve, Alan Greenspan suggested that in the short term those markets are so chaotic, it may impossible to predict the direction of the dollar. Several years ago, Warren Buffett, the world's greatest investor, bet big on a dollar free-fall. He had predicted that foreign investors would flee the United States in droves, sending the dollar down in a vicious spiral. He labeled the trade a "slam dunk," yet lost a reported billion dollars on the bet. During this period, the dollar softened some against the euro and pound but failed to dramatically collapse as Buffett had predicted.

Perhaps the most astute practical observation about the confusion surrounding foreign exchange markets was offered by hedge fund trader Louis Bacon. Bacon notes that up until the last decade and a half or so, most currency traders were former bond traders. As a result, it was natural that these individuals tended to concentrate on interest differentials in making bets in the currency markets. That created a sense of relative predictability. Yet with the increased globalization of financial markets which caused the world foreign exchange market to balloon in size, a massive influx of a new class of financial traders arrived on the scene. They were an army of former equity traders who tended to fixate not only on interest rate differentials but on growth differentials. In other words, what are the chances that the domestic conditions of an economy are conducive to healthy future growth such that foreign capital pours into that economy's currency?

As a result of this new reshaping of the currency trading community, any sense of predictability has been thrown out the window. At times, for example, the dollar has been influenced by growth differentials. Then suddenly interest differentials become the prominent market mover. And of course at times a combination of interest and growth differentials factor into the movement of the greenback.

Part of the confusion in policy circles relates to the difficulty in understanding the significance of current account and budget deficits in a global economy of huge cross-border savings shifts. It seems strange, for example, that the U.S. ten-year Treasury bond yield did not drop below 5.25 percent during the...