The Falling Dollar

The solution, not the problem

Dean Baker

In the same way that men are prone to boast about the size of cer­tain body parts, pol­i­cy­mak­ers like to tout the mer­its of a strong dol­lar. While the for­mer is usu­al­ly harm­less, pro­mot­ing an over­val­ued dol­lar can be an incred­i­bly destruc­tive eco­nom­ic pol­i­cy. For­tu­nate­ly, the Unit­ed States is mov­ing away from its high dol­lar days, although not quick­ly enough, and not before vast dam­age has been done.

The val­ue of the dol­lar is the main force equi­li­brat­ing trade, keep­ing the val­ue of imports in line with exports. When the val­ue of the dol­lar ris­es, it makes U.S. exports more expen­sive to for­eign buy­ers. For exam­ple, if the dol­lar ris­es by 30 per­cent against the euro, it will take 30 per­cent more euros for some­one liv­ing in France or Ger­many to buy a com­put­er or some oth­er item pro­duced in the Unit­ed States. In this sense a rise in the dol­lar is equiv­a­lent to putting a tar­iff on U.S. exports — it makes them more expen­sive, and there­by reduces demand for U.S. exports.

The rise in the dol­lar has the oppo­site effect on imports com­ing into the Unit­ed States. If it takes 30 per­cent few­er dol­lars to buy a euro, then items pro­duced in Europe (e.g., Ger­man cars or French cheese) will the­o­ret­i­cal­ly cost 30 per­cent less in the Unit­ed States. In this sense, a rise in the val­ue of the dol­lar is equiv­a­lent to pro­vid­ing a sub­sidy for all goods import­ed into the Unit­ed States. There­fore, the expect­ed result of a high dol­lar is an increase in imports. (In real­i­ty, how­ev­er, importers may not ful­ly pass along to con­sumers the cost sav­ings from a high­er dol­lar in low­er prices or the cost increas­es asso­ci­at­ed with a low­er dol­lar in the form of high­er prices.)

Unpleas­ant consequences

The Unit­ed States delib­er­ate­ly embarked on a high dol­lar pol­i­cy in 1995 when Robert Rubin took over as trea­sury sec­re­tary. Mea­sured against the cur­ren­cies of our trad­ing part­ners, the dol­lar rose by 30 per­cent between 1995 and its peak in 2002. The rise in the dol­lar had exact­ly the effect pre­dict­ed by stan­dard eco­nom­ic the­o­ry — exports fell, and imports rose. 

The high dol­lar pol­i­cy has an impor­tant class dimen­sion. The neg­a­tive impact of the high dol­lar is felt by the sec­tors of the econ­o­my that most direct­ly face for­eign com­pe­ti­tion, pri­mar­i­ly man­u­fac­tur­ing and there­fore man­u­fac­tur­ing work­ers. The Unit­ed States has lost more than 2.8 mil­lion man­u­fac­tur­ing jobs since 1995, almost one-fifth of its total, large­ly because of the over­val­ued dol­lar. Fur­ther­more, the loss of mil­lions of jobs that offer rel­a­tive­ly high wages for work­ers with­out col­lege degrees has placed down­ward pres­sure on the wages of less-edu­cat­ed work­ers in gen­er­al. In short, the high dol­lar has played an impor­tant role in redis­trib­ut­ing income from less edu­cat­ed work­ers to high­ly edu­cat­ed pro­fes­sion­als (e.g., doc­tors, lawyers and econ­o­mists), who are large­ly pro­tect­ed from for­eign competition. 

The high dol­lar has caused the U.S. trade deficit to soar to unprece­dent­ed lev­els. In the third quar­ter of 2004 the cur­rent account deficit (the broad­est mea­sure of the trade deficit, which includes inter­na­tion­al income flows like inter­est pay­ments and mon­ey sent home from immi­grant work­ers) was run­ning at an annu­al rate of $660 bil­lion, or 5.6 per­cent of gross domes­tic prod­uct (GDP). Trade data for Octo­ber and Novem­ber indi­cate that the fourth quar­ter deficit will be even larger. 

The cur­rent account deficit is sim­i­lar to a bud­get deficit. The Unit­ed States can run mod­est bud­get deficits (2 to 3 per­cent of GDP) indef­i­nite­ly. It can also run large bud­get deficits for a short peri­od of time, but it can­not run large bud­get deficits indef­i­nite­ly. After a time, lenders become wary of the government’s abil­i­ty to repay its debt, and they demand high­er inter­est rates on gov­ern­ment debt, such as trea­sury bonds, push­ing up inter­est rates through­out the economy.

The cur­rent account deficit is financed by for­eign­ers buy­ing up U.S. finan­cial assets. In the late 90s the deficit was financed pri­mar­i­ly by the will­ing­ness of for­eign investors to buy into the stock bub­ble. When the stock mar­ket col­lapsed, many for­eign investors start­ed buy­ing U.S. gov­ern­ment bonds. But in the last year and a half, they have become less will­ing to buy gov­ern­ment bonds — in part because of the fear of los­ing mon­ey on the falling dol­lar. For­eign cen­tral banks, in par­tic­u­lar the cen­tral banks of Japan and Chi­na, have picked up the slack, buy­ing up hun­dreds of bil­lions of dol­lars’ worth of U.S. gov­ern­ment debt in the last two years. This has tem­porar­i­ly sus­tained the val­ue of the dol­lar and kept inter­est rates low­er than they would be otherwise.

In the short term, the for­eign cen­tral banks are help­ing sup­port the U.S. econ­o­my, and there­fore their own export mar­kets. With­out their sup­port, the dol­lar would fall more sharply. This would lead to high­er import prices, which would in turn lead to high­er infla­tion as con­sumers and busi­ness­es are forced to spend more mon­ey for the same goods. High­er infla­tion would lead to high­er inter­est rates on home mort­gages and car loans, since investors typ­i­cal­ly expect that their return on loans will pro­vide a pre­mi­um above the rate of infla­tion. The result­ing falloff in home and car sales will bring the already weak recov­ery to a quick end. 

In the long run, how­ev­er, rely­ing on Japan and Chi­na to finance the U.S. bud­get deficit cre­ates greater prob­lems. Japan and Chi­na are under no oblig­a­tion to pay U.S. con­sumers to buy their prod­ucts (this is the effect of their cur­rent pol­i­cy of buy­ing up U.S. gov­ern­ment bonds). They can just as eas­i­ly pay any­one else to buy their prod­ucts, includ­ing their own con­sumers. While Japan, Chi­na and oth­er major exporters to the U.S. can­not devel­op new mar­kets overnight, they cer­tain­ly can devel­op alter­na­tive mar­kets in the span of a few years. When these coun­tries become less depen­dent on the U.S. mar­ket, they can dump their dol­lars any time they find it con­ve­nient. In the mean­time, these coun­tries are accu­mu­lat­ing almost $2 bil­lion a day, which may even­tu­al­ly be dumped on inter­na­tion­al finan­cial markets.

It will not be pret­ty, but the best thing for the Unit­ed States would be a quick fall in the dol­lar, which would pro­vide a rapid cor­rec­tion in the trade deficit, by rais­ing the price of imports and mak­ing our exports cheap­er to peo­ple liv­ing in oth­er coun­tries. While this rise in import prices will result in high­er infla­tion, there is no way that an increase in import prices can be avoid­ed. The high dol­lar pol­i­cy lets us live beyond our means in the short term by pro­vid­ing us with imports at extra­or­di­nar­i­ly low prices (just like a bud­get deficit lets us avoid tax­ing enough to pay for gov­ern­ment spend­ing), but we can­not indef­i­nite­ly bor­row mon­ey to import goods. It is best to reverse this high dol­lar pol­i­cy and let the dol­lar fall before we accu­mu­late even more debt and lose even more indus­try to for­eign competition. 

Cause vs. effect

Unfor­tu­nate­ly, the media has large­ly cloud­ed the pol­i­cy debate over the dol­lar by con­fus­ing cause and effect. Numer­ous reporters have blamed the fall in the dol­lar on the cur­rent account deficit, which in turn is blamed on the bud­get deficit. While such sto­ries res­cue Robert Rubin’s rep­u­ta­tion, they defy basic eco­nom­ic logic.

A bud­get deficit is sup­posed to lead to a cur­rent account deficit pre­cise­ly because it rais­es the val­ue of the dol­lar. Accord­ing to the text­book sto­ry, a bud­get deficit rais­es inter­est rates, which in turn caus­es for­eign investors to buy U.S. finan­cial assets (high­er inter­est rates makes U.S. assets more attrac­tive to for­eign­ers). When for­eign­ers buy U.S. finan­cial assets, the dol­lar ris­es, lead­ing to a cur­rent account deficit. In oth­er words, there is no way that a bud­get deficit can lead to the cur­rent account deficit, except through an over­val­ued dollar. 

In short, this is one prob­lem that can­not be blamed on Pres­i­dent Bush — except in his fail­ure to take steps to cor­rect the imbal­ance ear­li­er. The Clin­ton admin­is­tra­tion delib­er­ate­ly pushed a high dol­lar pol­i­cy that, like the stock bub­ble, gave Amer­i­cans a short-term illu­sion of pros­per­i­ty, mak­ing imports cheap and keep­ing infla­tion low. Just as the inflat­ed stock prices of the tech bub­ble could not be sus­tained indef­i­nite­ly, it will be impos­si­ble to sus­tain the over­val­ued dol­lar for long. The return to real­i­ty will be painful, but the pain will only be greater the longer it is delayed.

Dean Bak­er is co-direc­tor of the Cen­ter for Eco­nom­ic and Pol­i­cy Research and co-author of Social Secu­ri­ty: The Pho­ny Cri­sis (Uni­ver­si­ty of Chica­go Press, 2000).
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