This Is Your Currency on Drugs

An all-too-familiar story: The AP reports this morning that the dollar took another slide against the euro in the currency markets.  The administration has been rather cavalier about it thus far, making equivocal claims about how long it will tolerate a weakening dollar.  As the AP story indicates, its fall is tied to the continuing deficit problem; while the administration's talk of fancy accounting might help paper over the problem with the more dimwitted in Congress and the public, currency traders will not be fooled.

The real danger, as Brad Setser has written extensively, is that countries holding many hundreds of billions of dollars in reserves -- essentially propping the currency up and keeping our interest rates low -- will no longer see it in their interest to do so.  See this Economist article excerpted by Brad DeLong and recent posts from Setser here, here and here to get a sense of the problem.  Why do they continue to do so?  It's unlikely that they do so because they expect the dollar to recover soon.  With deficits as far as the eye can see, no plan to correct them, and growing trade deficits, those who talk about "fundamentals" like Snow has begun to do really mean "weak dollar."

Reserves held by these nations also serve a political purpose, especially in the case of China (upwards of $500b in reserves) and as such do not fit neatly into the efficient markets model of currency valuation.  And that makes murkier any predictions about when or whether they might dump the dollar.  The other aspect worth considering is that for the first time in the post-Bretton Woods world there is a single viable alternative to the dollar.

Let's take seriously the reporting of Daniel Gross of Slate (also on NPR) that drug lords are dumping the dollar in favor of the euro as their currency of choice.  The story has been echoed with amusement in the blogosphere, but let me say why this is more ominous than first appears.  It won't affect the exchange markets, but it does give a clearer picture of the tipping point from dollars to euros, and so presages a similar tipping point for national banks once the political stakes become relatively less important.

I would suggest that your average drug smuggler cares about only two things when choosing a currency: Can I make transactions without being traced, and how will I make the most money?  To simplify matters (although realistically, I believe), let's say that it becomes progressively easier to keep a transaction secret the more widely held a currency is.  What a drug smuggler does not care a whit about, however, is any political consideration or national allegiance in deciding what to hold in his or her wallet.  For the drug lords (not so much the guy on the corner you buy your dime bags from) they will have reserves of their own in order to finance their operations, and so care about the value of the money they spend tomorrow as well as what they spend today.  Yes, even drug lords care about the shadow of the future.

So, in choosing among widely held currencies, they want one they can make money from now and continuing into the future.  If we believe the reporting of Gross, these relatively politics-free market actors are passing the tipping point from dollars to euros.  Rather than reacting to the story over the holidays with a chuckle, I saw it as a very bad sign.  How much longer before China does the same?  Brad DeLong wonders, too.  Call me Chicken Little, but it is past time that we take the dollar problem seriously.

(For those interested, there is an active and fascinating literature on crime and economics exploring related issues, such as testing models of labor economics using cases and data in the black market.  Some of the best work in the field is by Steve Levitt at the University of Chicago, and here is a link to an abstract of one of his papers on the subject.)