Today, we're fortunate to have Jeff Frankel, Harpel Professor at Harvard's Kennedy School of Government, as a guest blogger. His blog is here.

The possibility that some Gulf states, particularly the UAE, might abandon their long-time pegs to the dollar is getting increasing attention (from Martin Feldstein and Brad Setser, for instance). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism -- most striking in Dubai -- is admirable and fascinating, but also now clearly indicative of overheating. Indeed inflation, as predicted, has risen alarmingly. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a couple of years ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. Today's reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn't solve the problem if the price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere. (I call it PEP, for Peg the Export Price [pdf]) I was pleased to see recently that the Financial Times mentioned this option approvingly ("Dollar-pegged Out," July 7):

"The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak."

Several observations:

• As in recent years, the NIIP to GDP ratio continues to deteriorate.
• However, the NIIP to GDP ratio as of end-2007 is improved relative to the originally reported end-2006 NIIP/GDP ratio.
• In the last year, the dollar change in the NIIP deviates substantially (i.e., is more positive) than the corresponding current account reported on a NIPA basis. This repeats the pattern from the previous five years.
• Interestingly, 2005 stands out by far as an outlier, wherein the the NIIP improves while the CA is in substantial deficit.
• There appears to be a measurable correlation between dollar depreciation against other major currencies and the deviation between change in NIIP and CA.

The first two observations are illustrated in Figure 1.

The second two observations are illustrated by Figure 2.

The last observation is illustrated by the scatterplot in Figure 3, applying to data over the 1992-07 period.

While the regression coefficient is not significant, allowing for a dummy for the anomalous 2005 observation (Brad Setser's decomposition attributes this effect to mostly market valuation changes, if I read his graph correctly), one finds that each 10% depreciation in the dollar against a basket of major currencies induces a 2.5% increase in the gap between the NIIP change and the current account (all expressed as a ratio of GDP). Specifically:

dev = 0.01 + 0.25dep + 0.097dum05

Adj-R² = 0.68, SER = 0.017, N=16, all coeffs sig at 5% msl.

Should the dollar appreciate in 2008 against other major currencies, then one should expect the valuation effect to be reversed. A cessation of dollar depreciation will mean on average the gap between the change in NIIP and the CA (as a share of GDP) will be only 1%. (Another point I've highlighted is that the cumulative current account and NIIP converge during recessions -- see "Can Gravity Be Defied?".

In the title of this post, I mentioned "What's Missing". One interesting point highlighted in Frank Warnock, et al.'s paper, presented at the UW-Madison conference on current account sustainability a couple months ago is that it is difficult to rely upon some dark matter explanation for the differential rates of return on US owned assets abroad versus foreign owned assets in the US. Rather, previous studies have mismeasured the stocks of assets, and mismatched flows to stocks, imparting substantial measurement error to rates of return.

In an extensive forensic analysis indicates Warnock et al. conclude:

In this paper we provided a brief summary of some of the theories of U.S. current account sustainability and viewed them through the lens of the relative reliability of various items in the international accounts. From the perspective of relative reliability, the dark matter view fails, as it rests on an assumption that income streams are the most accurate items in the entire set of international accounts. Given that the bulk of income streams are themselves estimates based on other items in the accounts, this assumption is false. The exorbitant privilege view also fails. In its original form it rested on the assumptions that the current vintage of revised positions and flows form a consistent dataset and that all "other adjustments" are best thought of as valuation adjustments. In this paper we show that this is not true, in part by calculating “other adjustments” by asset class and filling some known holes in the international accounts. The set of accounts we produce by doing so are entirely consistent with a small cross-border returns differential, suggesting that there is no evidence that the U.S. can earn its way to current account sustainability.

One particularly interesting point Frank identifies, which was news to me, was that real estate purchases are not included in the balance of payments data, and hence not in the international investment position estimates.

In principle, cross-border transactions and holdings of residential real estate should be included as part of direct investment, as is currently the case for commercial real estate. In practice, individual homeowners are not surveyed and hence these data are omitted from the recorded DI figures. To the extent that foreign activity in the U.S. residential real estate market is of the same magnitude as the level of activity of U.S. residents in the foreign real estate markets, there is no net impact on the international transactions accounts. However, recent surveys conducted by the National Association of Realtors (NAR) suggest that this may not be the case.

Additional discussion of the IIP release from Brad Setser.