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The rise in the dollar over the past year by an average of more than 10 percent against other major currencies has been a surprise to many analysts. The expectation was that the large U.S. current account deficit, a slowing U.S. economy, falling U.S. interest rates, and an end to the U.S. stock market bubble would all cause the dollar to weaken. Many analysts expected that the euro would be the strongest currency of 2001.
The Current Account Deficit Is a Poor Guide to Dollar Behavior
The broad strength of the dollar, even in the face of a slowing U.S. economy and a falling U.S. stock market, is based upon the determinants of the demand for dollars and the supply of dollars in global foreign exchange markets. The widely bemoaned U.S. current account deficit, currently more than $400 billion annually, or well above a billion dollars a day, measures the supply of dollars flowing into global foreign exchange markets. Many market players expect that when a country’s current account deficit goes up and the supply of its currency in the foreign exchange markets rises, the value of that currency will go down.
But, in fact, during most of the time that the U.S. current account deficit has risen, the dollar has grown stronger. Up until last year the reason was that a rapidly growing U.S. economy that demanded more goods and services in global markets, and therefore had a larger current account deficit, was also a magnet for inflows of capital to invest in a rapidly rising U.S. stock market. In short, during the expansion phase of the U.S. cycle, especially during the three years ending in 2000, although the supply of dollars into global financial markets rose (as measured by a rising current account deficit), the demand for dollars rose even more rapidly, and so equilibration of demand and supply required that the dollar appreciate.
But the dollar has continued to rise since last spring even as the current account deficit has gone up, the U.S. economy has slowed down, and the stock market has dropped. To explain this it is important to remember that U.S. stocks are not the only thing that foreign investors buy. The weakening U.S. economy and Fed rate cuts have pushed up the value of U.S. government bonds and some corporate bonds, and foreign investors have been buyers. Since buying the bonds requires buying U.S. dollars, rising foreign purchases of U.S. bonds have contributed to the global demand for dollars, thereby helping the dollar to remain strong.
Beyond purchases of U.S. bonds, foreign investors are also heavy buyers of U.S. real property. For foreign corporations and wealthy individuals, the U.S. property market represents an excellent safe haven and diversification opportunity. Foreign corporations are always on the lookout for attractive U.S. properties, just as wealthy families living in emerging markets with less-secure property rights are always eager to purchase U.S. real estate, especially in attractive markets on the coasts and in urban centers.
Many Exporting Countries Cannot Afford a Weaker Dollar
Another basic factor has kept the dollar strong within the context of a rapid slowdown in global demand. Recall that it was the United States that provided the major engine of demand to purchase the resurgence of world output that followed the sharp easing in financial markets after the 1997–1998 Asian crisis ended. In effect, many countries, in Asia and emerging markets especially, that are heavily dependent on exports have been anxious to maintain or cushion the fall in the growth of demand for those exports as the world economy has slowed over the past year. For a country whose export growth is heavily dependent on sales to the United States, a sharp slowdown in U.S. economic growth is bad enough. Even worse, a drop in the value of the dollar, equivalent to a rise in the value of foreign currencies, would further depress sales to the United States because it would make U.S. goods more attractive than imports to U.S. consumers and thereby further depress the demand for the exports flowing to the United States from the rest of the world.
The strength of the dollar against the currencies of chronic surplus countries may seem especially counterintuitive, but seen from the standpoint of the need to maintain the demand for the exports of surplus countries, the dollar’s continued strength is not surprising. Remember that a country with a large current account surplus, like Japan, for example, experiences a steady net inflow of foreign currency. Instead of creating a supply of yen to the world, Japan’s surplus (running about $9 billion a month) creates an underlying demand for yen that if not met by capital outflows would cause the yen to strengthen, thereby exacerbating deflationary tendencies in Japan. This problem occurred in 1995 when the yen spiked to about 80 yen per dollar at a time when Japan’s stock market was falling and the economy was rapidly weakening.
During the last half of 1999, when it was expected that the Japanese economy would recover and foreign investors were eager to put funds into Japanese stocks, the yen did rise by more than 20 percent against the dollar. At that time, Japan’s central bank in effect simulated capital outflows by purchasing dollars to prevent the yen from appreciating too far. Since that time, Japan’s recovery has fizzled, its stock market has fallen, and private capital outflows have more than overwhelmed the intrinsic demand for yen arising from Japan’s current account surplus. As a result, the yen has depreciated against the dollar by about 20 percent since last summer, even as the U.S. economy has slowed.
The yen’s depreciation against the dollar becomes a sensitive issue in Asia because of the fundamental problem facing the global economy–the lack of the demand for output. As the yen weakens more than other Asian currencies, Japan is able to command a larger share of the shrinking market for global exports at the expense of other Asian exporters such as China, Taiwan, Korea, and especially Hong Kong, whose currency is pegged to the U.S. dollar. It is no accident that the artificial strength of the Hong Kong dollar has precipitated a sharp deflation in Hong Kong accompanied by weakness in the Hong Kong stock market.
Currency Strength Can Be a Danger When the Economy Is Weak
All of these considerations point to a fundamental truth. In a world where demand, not supply, is scarce, as is the case now after a global investment spending boom followed by falling profits, currency strength is a problem. It is deflationary because it shifts demand away from the products of the country with the strong currency and onto the products of the country with the weaker currency. Because demand growth has held up better in the United States than it has in most other economies, thanks to the U.S. consumer, the strong dollar is a broad reflection of the idea that the United States is the only major economy in the world that can afford a strong currency right now.
This important truth is underscored by comparison with the sad case of Argentina. The currency of Argentina has been fixed to the dollar in an attempt to expedite heavy borrowing from abroad. If Argentina’s currency is as good as the dollar, then it is possible for Argentina to arrange for large external financing, as it has done. The problem arises when global demand starts to shrink and Argentina is saddled with a strong currency by virtue of its peg to the dollar. While Argentina’s trading partners allow their currencies to depreciate against the dollar, thereby helping to maintain demand in their countries, Argentina is forced onto a deflationary course that sharply depresses growth in the economy. A sharp slowdown in growth reduces revenues and increases the borrowing needs of the Argentine government. The domestic political pressure arising from the deflationary forces operating in Argentina makes foreigners reluctant to lend to finance Argentina’s government deficit, and so a crisis like that emerging in March of this year arises. In the short run, Argentina has met its financing needs essentially by lowering reserve requirements at banks and allowing them to use the proceeds to purchase an additional issue of government securities. This approach cannot be sustained unless U.S. and global demand stop shrinking soon.
But the case of Argentina is illustrative. A slowdown in the growth of global demand, especially when it emanates from the United States, means that any country whose currency strengthens against the dollar experiences an additional deflationary impulse. The corollary is that an export country dependent on U.S. markets must allow its currency to depreciate if it is to cushion the negative impact on growth resulting from a U.S. slowdown. Countries such as Canada, Australia, and New Zealand have all allowed their currencies to weaken in an effort to cushion the impact upon their export-oriented economies of a slowdown in global growth, thereby enhancing U.S. dollar strength.
Not Even the Euro Has Gained against the Dollar
Perhaps the biggest surprise for many currency analysts has been the failure of the euro consistently to strengthen against the dollar. It fell from a value of $1.20 at its inception in January 1999 to a low of 82 cents last fall. It then touched 96 cents early this year and has since dropped back to 88 cents. The slowdown in the United States has been sharper than the slowdown in Europe (although European stock markets have been closely tied to falling U.S. stock markets).
The best way to understand the continued strength of the dollar, even against the euro, is to imagine yourself as a global portfolio manager charged with maintaining the value of your holdings in a shrinking world economy. Where do you put your assets? The stock market in countries with balance of payments surpluses is vulnerable as exports fall. So too are bond markets in emerging markets where either currencies are being allowed to fall in order to cushion the impact of slowing exports or the ability to meet borrowing needs is in question. You might keep some funds in European bond markets, and indeed, many investors are doing so. But U.S. government bonds are even more attractive by virtue of the fact that the United States is running a budget surplus that in turn is reducing the supply of U.S. government bonds available to the market. Many European countries either have, or expect to have, budget deficits.
The U.S. central bank, the basic arbiter of the value of the currency, is better established and has a longer record of managing the economy than the relatively new European central bank. The European Central Bank presides over a diverse currency area where the needs for monetary policy vary widely. A slowing German economy needs an easier policy while an overheating Irish economy needs a tighter policy, yet both are under the jurisdiction of the European Central Bank since both are in the euro area. Conflicts arise and blur the direction of monetary policy, with the weaker countries often pressing harder for easier policy than the stronger countries press for tighter policy.
Looking forward, we can see that some additional risks may be attached to the euro’s transition away from the physical use of national currencies early in 2002. While ultimately the transition will take place, the requirement that the Germans, the French, and the citizens of all the countries in the European Union turn over national currencies in exchange for euros may cause some political controversy that, in turn, casts doubt on the stability of the euro. No such problems face the Federal Reserve or the dollar currency area.
What Could Weaken the Dollar?
All of this is not to say that the dollar could never weaken. Obviously it will continue to rise and fall as the supply of dollars and the demand for dollars in world markets change over time. The two pillars of dollar strength right now are the need to improve access to reduced demand growth in the United States in a world of shrinking demand for exports and, second, the primacy of the dollar and especially U.S. government bonds as a superior store of value at a time when the risks attached to a slowing world economy are rising. Investing in the United States and owning dollars is perhaps not absolutely as attractive as it was in 1999, but the strength of the dollar suggests that since then it has become relatively more attractive. In other words, it is the relative attraction of a currency that determines the exchange rate, not its absolute attraction.
Developments that could weaken the dollar include a more rapid recovery of demand elsewhere in the world. Were the Japanese economy radically to deregulate or otherwise to create large domestic investment opportunities, more of Japan’s large supply of savings would stay at home while capital outflows from Japan would fall. Other things being equal, the dollar would weaken. The weakness of the dollar or the strengthening of the yen would be limited by Japan’s need and desire to maintain access to global markets, but a strong recovery of Japan’s domestic economy still has the potential to weaken the dollar. Similarly, domestic strength in Europe, which would redirect investment funds into the European economy and away from U.S. assets, would strengthen the euro against the dollar.
A country’s central bank is a fundamental determinant of the strength of its currency, and no doubt Alan Greenspan’s term as Federal Reserve chairman has had a good deal to do with the continued strength of the U.S. dollar. Confidence in management of monetary policy and a commitment of the central bank to avoid inflation while sustaining solid growth are keys to currency strength. At some point in the next three years, the leadership at the Federal Reserve will change, and the choice of the new Federal Reserve chairman will either reassure or disconcert markets. Whatever the outcome, Chairman Greenspan’s leadership of the Fed will be a very difficult act to follow, and the dollar may experience some transitional weakness as markets get used to new leadership at the Fed.
The U.S. Can Stand a Weaker Dollar Better than the Rest of the World Can
The best way to understand the strength of the dollar over the past year is to realize that in a shrinking world economy a weaker dollar would be a far bigger problem for the rest of the world than it would be for the United States. A weaker dollar would enhance the demand for U.S. output while simultaneously exporting deflation from the United States in the form of stronger currencies and weaker exports elsewhere. It would mean that global demand would be shifted toward the United States. Such a shift to a weaker dollar could come as a byproduct of a sharp slowdown in U.S. consumption and could even accompany a falling current account deficit, thereby compounding the confusion of those who try to track currency values by looking at the current account alone. The risk of a sharp slowdown in U.S. consumption growth is not negligible in view of the fact that U.S. consumption has continued to grow at a rate 2 percentage points above the growth rate of disposable income, with the difference being financed by a sharp rise in consumer borrowing. Whatever the outcome, events very probably will continue to prove that following the U.S. current account deficit is not a reliable guide to the path of the dollar.
The news behind possible dollar weakness is the key to interpreting its significance. If the dollar weakens because growth picks up in Japan or Europe, then that would be a positive sign that leadership for recovery of global demand growth has shifted outside of the United States, as might normally be the case from time to time. Alternatively, if the dollar drops largely because of a collapse in U.S. demand and sharply weaker U.S. stocks, a self-reinforcing global deflation could be the result. Foreign central banks would have to ease aggressively to try to contain the deflation. Right now, the Bank of Japan is unable or unwilling to ease and the European Central Bank is unwilling to ease. Let us hope that picture changes rapidly if the U.S. consumer, exhausted by losses in the stock market, rising debt, and a sharp rise in tax burdens, decides to stop spending.
John H. Makin is a resident scholar at AEI.
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