Should America want a strong dollar? It's complicated
Feb 9th 2017, 17:29 BY R.A. | WASHINGTON
IN AN experience we have all had, Donald Trump, unable to sleep, reportedly rang his National Security Advisor at 3:00 in the morning to ask whether America should want a strong dollar or a weak one. Look, there are no stupid questions. This one is actually more interesting than you might think. There are a few ways to answer it.
One way is to ask what it would mean if there were a random rise in the dollar (caused, say, by noise trading). Tyler Cowen takes this approach. Since most Americans have their incomes and wealth in dollars, a rise in the dollar would generally be good for America and bad for non-Americans: with caveats, including the fact that a stronger dollar might cause financial trouble for indebted emerging markets which could feed back into the American economy.
That's fine and all, but the dollar usually does what it does for a reason, or some set of reasons, and the answer to the question depends on why the dollar is strong or weak. Matt Yglesias gives his answer using this approach. If the dollar is rising because the Fed is inducing a deflationary recession, that's probably not good for anyone. (This is not outside the realm of plausibility, as it happens; Britain suffered years of painful deflation in the 1920s in order to defend sterling's peg to gold at an overvalued rate, only to then subsequently devalue during the Depression.) If the dollar is rising because America has discovered something amazing (like oil, or pluots) and the world cannot get enough of it, then that's probably good for everyone—though it is worth remembering that in all of these cases there are winners and losers, in America and elsewhere.
But another way to approach to the question is to ask whether the dollar is overvalued or undervalued. If the dollar is overvalued, then a bout of weakening would be a healthy thing. How can you tell if a currency is overvalued or undervalued? Well, you can consult your nearest Big Mac index. Alternatively, you can check the current-account balance. If a country is persistently running current-account surpluses, its currency is probably undervalued; deficits, overvalued. America has been running current-account deficits since the early 1980s, therefore its currency is overvalued and a weaker dollar would be better.
Ok, but hold on. How is it that the dollar hasn't adjusted to its appropriate value after nearly 40 years. That, it turns out, is the critical question.
The dollar has been overvalued all this time because the dollar is a reserve currency. Not just a reserve currency, but rather the world's dominant reserve currency, by a long shot. It holds that position partly for reasons of path dependence: because the dollar was the anchor currency in the postwar Bretton Woods agreement, other economies accumulated lots of dollar reserves to help maintain their fixed exchange rate. It holds the position partly because of network externalities; if lots of people do their trade invoicing in dollars, it is convenient for you to also do your business stuff in dollars to keep everything simple. And it holds that position in large part because no other currency, or country, is as capable of providing reserve-currency services. America has a very large and rich and stable economy, a high tax-revenue generating capacity, an extremely credible central bank, a stable democracy (knock wood), massive military and diplomatic power, broad and deep financial markets, and so on. The point is: America can provide large amounts of dollars, and government bonds, and other dollar-denominated assets without getting anywhere near the sorts of crises that might lead to sudden or unexpected changes in value in those dollars and bonds and such. Just as important, America has historically accepted the role of reserve-currency provider and the responsibilities that entails: like cooperating with other countries in crises to provide emergency dollar liquidity. America is the total package, or has been anyway.
What that has tended to mean, then, is that foreign firms and governments buy American government bonds by the truckload. Foreign appetite for dollars and dollar assets—even the super boring low-yield ones—allows Americans to buy more than they produce. It seems like a win-win situation. The dollar-as-a-reserve-currency is a public good of sorts, a lubricant for global trade and finance, provided by America to the rest of the world. In return, Americans get to buy more than they make, forever. As this week's column explains, though, there are downsides:
An overvalued currency and persistent trade deficits are fine for America’s consumers, but painful for its producers. The reserve accumulation of the past two decades has gone hand-in-hand with a soaring current-account deficit in America. Imports have grown faster than exports; new jobs in exporting industries have not appeared in numbers great enough to absorb workers displaced by increased foreign competition. Tariffs cannot fix this problem. The current-account gap is a product of underlying financial flows, and taxing imports will simply cause the dollar to rise in an offsetting fashion.
America’s privilege also increases inequality, since lost jobs in factories hurt workers while outsize investment performance benefits richer Americans with big portfolios. Because the rich are less inclined to spend an extra dollar than the typical worker, this shift in resources creates weakness in American demand—and sluggish economic growth—except when consumer debt rises as the rich lend their purchasing power to the rest.
Chalk the headaches generated by low interest rates up to the dollar standard, too. Some economists reckon they reflect global appetite outstripping the supply of the safe assets America is uniquely equipped to provide—dollar-denominated government bonds. As the price of safe bonds rises, rates on those bonds fall close to zero, leaving central banks with ever less room to stimulate their economies when they run into trouble.
So one could ask whether a strong dollar is better or a weak one. But one could also ask whether it is in America's long-term interest to continue supporting the global dollar standard. In my view, it is neither sustainable or desirable for America to continue to play this role on its own. On the other hand, the status quo is preferable to the chaotic destruction of the dollar standard in the absence of a ready replacement. Put in the shoes of Mike Flynn, Mr Trump's National Security Advisor, I'm not sure quite how I'd respond. But the answer would start with, "First, Mr President, give me your phone."
Donald Trump and the dollar standard
A pillar of global financial stability is under threat
Feb 11th 2017
TRUMPISM is in part an expression of American exhaustion at bearing burdens it first took up 70 years ago. Donald Trump has moaned less about the dollar than about shirking NATO allies or cheating trade partners. Yet the dollar standard is one of the most vulnerable pillars of global stability. And the world is far from ready for America to ditch its global financial role.
Unlike other aspects of American hegemony, the dollar has grown more important as the world has globalised, not less. In the Bretton Woods system devised for the post-war world, Western economies fixed their exchange rates to the dollar, which was in turn pegged to the price of gold. After the fracturing of this system under the inflationary pressures of the 1970s, the dollar became more central than ever. As economies opened their capital markets in the 1980s and 1990s, global capital flows surged. Yet most governments sought exchange-rate stability amid the sloshing tides of money. They managed their exchange rates using massive piles of foreign-exchange reserves (see chart). Global reserves have grown from under $1trn in the 1980s to more than $10trn today.
Dollar-denominated assets account for much of those reserves. Governments worry more about big swings in the dollar than in other currencies; trade is often conducted in dollar terms; and firms and governments owe roughly $10trn in dollar-denominated debt. New research by Ethan Ilzetzki, of the London School of Economics, and Carmen Reinhart and Kenneth Rogoff , of Harvard University, concludes that the dollar is, on some measures, more central to the global system now than it was immediately after the second world war. It remains the world’s principal “anchor” currency, against which others seek to limit volatility.
America wields enormous financial power as a result. It can wreak havoc by withholding supplies of dollars in a crisis. When the Federal Reserve tweaks monetary policy, the effects ripple across the global economy. Hélène Rey of the London Business School argues that, despite their reserve holdings, many economies have lost full control over their domestic monetary policy, because of the effect of Fed policy on global appetite for risk.
Leaders of other economies bristle at this. During the heyday of Bretton Woods, Valéry Giscard d’Estaing, a French finance minister (later president), complained about the “exorbitant privilege” enjoyed by the issuer of the world’s reserve currency. America’s return on its foreign assets is markedly higher than the return foreign investors earn on their American assets (foreign governments hold vast amounts of safe but low-yielding dollar assets, like Treasury bonds, as reserves). That flow of investment income allows America to run persistent current-account deficits—to buy more than it produces year after year, decade after decade.
This has become a privilege America seems eager to discard. An overvalued currency and persistent trade deficits are fine for America’s consumers, but painful for its producers. The reserve accumulation of the past two decades has gone hand-in-hand with a soaring current-account deficit in America. Imports have grown faster than exports; new jobs in exporting industries have not appeared in numbers great enough to absorb workers displaced by increased foreign competition. Tariffs cannot fix this problem. The current-account gap is a product of underlying financial flows, and taxing imports will simply cause the dollar to rise in an offsetting fashion.
America’s privilege also increases inequality, since lost jobs in factories hurt workers while outsize investment performance benefits richer Americans with big portfolios. Because the rich are less inclined to spend an extra dollar than the typical worker, this shift in resources creates weakness in American demand—and sluggish economic growth—except when consumer debt rises as the rich lend their purchasing power to the rest.
Chalk the headaches generated by low interest rates up to the dollar standard, too. Some economists reckon they reflect global appetite outstripping the supply of the safe assets America is uniquely equipped to provide—dollar-denominated government bonds. As the price of safe bonds rises, rates on those bonds fall close to zero, leaving central banks with ever less room to stimulate their economies when they run into trouble.
A new golden age
A benign solution seems obvious: the dollar should share its role with other currencies. But one candidate to share the load—China’s yuan—is inhibited by tight limits on Chinese financial markets. Nor is increased dependence on China an attractive option for governments seeking to reduce their exposure to authoritarian-minded, transparency-averse regimes with unclear motives. The role of the euro, the other logical option, is constrained by existential political risk and the scarcity of safe euro-denominated bonds. What is more, the world’s big economies have much to lose from an end to American monetary hegemony. Their politically convenient trade surpluses for one; the value of the enormous piles of dollar-denominated assets for another.
History suggests two ways in which Mr Trump might undermine the dollar’s role. Bretton Woods broke apart as a result of a fatal flaw: governments were desperate for dollars, but in creating more of them America fanned inflation, which made its gold peg unsustainable. Similarly, should Mr Trump’s efforts to make America great again through tax cuts and spending lead to ever larger budget deficits and rising inflation, American assets might lose their lustre. America might resemble the 1970s again: with soaring prices and interest rates, but free of its exorbitant burden.
Alternatively, the dollar might go the way of the inter-war gold standard. That collapsed amid a breakdown in international co-operation, as governments of uncompetitive economies put up tariffs and then withdrew from the system altogether through the erection of capital controls. It would be tragic if history’s lessons were forgotten and had to be learned all over again.
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