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Charles Engel:Flight to Safety and the Strength of the Dollar

Charles Engel

Charles Engel, the Donald Hester Professor of Economics at the University of Wisconsin. He holds a Ph.D. from the University of California - Berkeley and has made outstanding contributions in the fields of international economics and macroeconomics. He serves as the editor of the Journal of International Economics and ISOM Special Issue of the Journal of International Economics. Publications: “Liquidity and Exchange Rates: An Empirical Investigation.”Debauchery and Original Sin: The Currency Composition of Sovereign Debt.”

Charles Engel:Flight to Safety and the Strength of the Dollar

During times of global financial stress, it is often said that there is a "flight to safety", in which global investors increase their demand for U.S. dollar assets, particularly U.S. Treasury assets. What exactly motivates this flight to safety?

On the one hand, the empirical fact that the dollar appreciates during times of global stress does indicate that dollar assets are low-risk assets, in the sense that they are like insurance contracts. Their returns in foreign currency (in RMB, euros, or yen) increase in global downturns because of the dollar appreciation. But the appreciation cannot be caused by increased demand for insurance, because when the downturn occurs, the insurance benefit is priced into the dollar. As an analogy, when a building catches on fire, it is too late to buy fire insurance, because the price of the insurance would be so high that it would offset any payout from the insurance.

But there is another sense in which there is a flight to safety, which is that it arises from a precautionary need for liquidity. Financial institutions particularly face uncertain funding during times of global financial stress. They would like to carry liquid assets on their balance sheets in order to insure against possible losses of funding sources and, therefore, being unable to roll over funding of their more illiquid investments.

The evidence shows that financial intermediaries do increase their demand for liquid assets during times of financial uncertainty, particularly dollar assets which are considered the most liquid assets globally. It is this increased demand for dollar assets during times of global pressure that leads the dollar to appreciate.

In the current economic situation, there are two reasons for the strength of the dollar. First, the Federal Reserve has tightened monetary policy more aggressively than many other central banks. In part, this reflects the fact that the supply shock of higher oil and food prices is less harmful to the U.S. economy since the U.S. is a net exporter of these goods, and in part, it reflects greater inflationary pressure in the U.S. than in some other countries (such as Japan.) The second reason for the appreciation of the dollar is the "flight to safety" - the increase in the precautionary demand for liquid dollar assets.

The fact that the dollar appreciates during times of global uncertainty does mean that the dollar assets have low risk because of their insurance properties. That low risk means that the U.S. enjoys what is sometimes called an "exorbitant privilege" because its borrowing rates are low given that these assets are considered to have good risk properties. Additionally, the rate is low because of the liquidity of the assets - investors perceive a non-monetary return from holding U.S. Treasury bonds arising from their liquidity, so are willing to accept a lower monetary rate of return. In other words, the fact that the U.S. government bonds are valued for their liquidity leads to lower expected returns on those bonds for two reasons: 1) directly, because investors are willing to accept lower returns in exchange for higher liquidity; and 2) indirectly because the liquidity makes the dollar appreciate during times of global strain, which enhances their risk properties.



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