Arnold Kling

The Tallest Pygmy

Arnold Kling, Great Questions of Economics
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According to some venerable yardsticks, U.S. assets are overvalued. In this macroeconomic Jeremiad, Morgan Stanley's Steve Roach offers a possible explanation.

The Teflon-like resistance of the US dollar is yet another manifestation of this pervasive sense of denial. Currencies, of course, are relative prices. And in a synchronous global recession everyone gets hurt. Yet if a US-centric world tumbles into recession, goes the logic, the dollar is still viewed as the "tallest pygmy."

The indicators of overvaluation are the price-earnings ratio in the U.S. stock market (still far above historical norms) and the large deficit in the U.S. balance of trade, due to an over-valued dollar. Roach believes that eventually both of these mispricings must be corrected.

If you are an investor who shares Roach's concerns, then you should buy assets from countries outside the United States. But that is where the "tallest pygmy" issue arises. Other industrial economies, such as Japan and Europe, are plagued by institutional rigidities. Less-developed countries remain risky (as Argentina illustrates). China may be on a high-growth path, but do you want to bet on a Communist country? India also has been performing well in recent years, but can it truly overcome its history of ethnic quarrels and general corruption?

Roach thinks that the Internet bubble created imbalances in the economy that will be costly to correct. This contrasts with Hal Varian's view (see post number 7 on the first archive), which is that the rest of the economy can absorb the former dotcommers relatively easily and productively.

Discussion Question. Suppose that Roach is correct, and we experience a decline in the stock market and a sharp drop in the value of the dollar in relation to foreign currencies. What industries would expand as a result? What industries might collapse? Could the United States labor market make the necessary adjustments without going through a period of high unemployment?

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