More Dollars and Sense

(Part II of Dollars and Sense)

Q: Does inflation cause the dollar to decline?

or

Q: Does a declining dollar cause inflation?

A: Yes!

Q: Does a declining dollar stimulate our economy?

or

Q: Does a declining dollar make us poorer?

A: Yes!

No sooner had the Fed acquiesced in the markets' desire for a substantial ease in monetary policy on 9/18 (and further ease on October 31) than the hand-wringing began over the resulting acceleration in the decline in the dollar. If it's not one thing, it's another.

As the apparently contradictory answers to the questions above suggest, the dollar is a tricky topic after having been out of the limelight for several years. Beginners should exercise caution.

Ben Stein's father, the excellent economist, Herb Stein, is alleged to have said that if something is inevitable, it will happen. He probably should have added, "sooner or later," since a decline in the dollar has been inevitable for many years. Economists have forecasted a decline in the dollar for so long without result, that they finally gave up. Financial journalists too young to remember road runner cartoons were taken by surprise and had some difficulty sorting it all out.   

As some of you will recall, the roadrunner in those cartoons would skid to a stop at the edge of the cliff as Wile E. Coyote, in hot pursuit, overran the cliff.  But, miraculously, the Coyote continued running until he finally looked down.  Apparently, what happened to the dollar was that someone finally looked down.

Those of us over a certain age learned in Econ 101 that the supply and demand for dollars in the foreign exchange markets derived primarily from trade in goods and services, with equilibrating or balancing capital flows financing whatever current account deficit or surplus emerged. But, in recent years, capital flows increasingly became "independently motivated" and took on a life of their own. We know that, but we still have difficulty grasping the idea that trade deficits might just as well be thought of as financing capital inflows and that trade surpluses may be thought of as financing capital outflows.  

What we do know is that the overall balance of payments always balances by the Grace of God, double-entry bookkeeping, and by definition. Total debits always equal total credits.  Debits in a country's balance of payments give rise to a home currency demand for foreign exchange.  Credits give rise to a foreign exchange demand for the home currency.  So, just as debits and credits are always equal in an accounting sense, so is the quantity of foreign currency demanded and supplied, and bought and sold, on foreign exchange markets.

Whether this accounting identity may or may not (probably not) represents "equilibrium" depends on whether market participants are satisfied with the outcome.  If not, their actions will move the balance of payments and exchange rates toward equilibrium through all sorts of interdependent changes.   

Can policymakers ignore the declining dollar and the current account deficit?

Yes, benign neglect has been the unofficial policy for years and the sky hasn't fallen-although Chairman Greenspan might say it's been measurably weakened. If strong capital flows into the United States resume, the dollar could be stabilized or even appreciate obviating a need for narrowing or eliminating the current account deficit.  This must be what the talking heads have in mind to order up a strong dollar without acknowledging any need for more balanced trade in goods and services. With this outcome, the continued capital inflow will continue adding to foreign claims on U.S. assets with whatever future problems that may pose.

What if capital inflows aren't sufficient to stabilize the dollar or cause it to appreciate?

Then the current account deficit that requires financing by capital inflows will have to continue shrinking through some combination of reduced imports and increased exports.  That may require further depreciation in the dollar, although the impact of the depreciation that's already occurred has likely not been fully realized yet. It takes time for the relative price changes associated with exchange rate changes to affect the level of imports and exports along with the shifting of labor and capital resources into export industries and industries that compete with imports.

What would it take to attract enough capital to match the current account deficit without further dollar depreciation?

Remember that the amount of capital inflow required will diminish as the depreciation that has already taken place continues to shrink the current account deficit.  The lower level of the dollar stimulates exports and diminishes imports.  With respect to capital inflows, the level of the dollar is less important than expectations of what is likely to happen to the dollar during investment horizons.  The fact that the dollar is currently "cheap" shouldn't attract capital unless investors expect it to become even cheaper after they invest in the U.S.  The incentive to invest will increase as the dollars decline begins to give rise to expectations of its reversal.  We may or may not be near that point already. However, efforts to "talk up" the dollar, if successful could keep foreign investment at bay and ironically lead to the greater depreciation needed to support it through trade rather than through investment.

Can benign neglect work in more than the superficial sense of accounting identities?

Yes, not only does the balance of payments always balance in an accounting sense, it tends to move toward equilibrium in a more fundamental sense of imbalances being self correcting.  To a very large extent, more imports lead to more exports and more exports lead to more imports.

When we import goods and services (or make unilateral transfers abroad) foreign exporters and gift recipients get dollars that can (and ultimately will) be used to purchase U.S. goods and services (or assets).  It probably won't be the foreign exporter that uses the dollars to import from us, but his newly acquired dollars will be sold in the foreign exchange market to those who need them for that purpose. 

By the same token, our exports, by earning us foreign exchange, give us the wherewithal to import more.  The argument is the same as above in reverse.  The point is that, left alone, import and export balances are self correcting.  Residual trade deficits or surpluses are tiny compared to the total trade and result from voluntary transactions affecting our capital accounts.  The exchange rate and other variables keep changing until market participants are satisfied with the outcome of millions of decisions to import, export, borrow and lend.

What about jobs?  Won't the trade balance affect jobs?

I'm glad you asked that question.  Most critics of free trade don't ask it; they just (incorrectly) assume the worst.  In other words, they associate a trade deficit with a loss of jobs.

Before answering in the context of this discussion, let me digress a moment and point out that the number of jobs we have roughly equals the number of people in the labor force willing to work.  If wages are too high for certain skill levels, potential workers will bid them down to become employed, i.e., if minimum wage laws don't become air tight.

The answer to the question of whether trade deficits cause unemployment is parallel to the discussion in previous paragraphs.  If imports beget exports, then jobs lost to imports will be matched by jobs created in export industries.  And, vice versa.

If restricted trade is suddenly freed up, the reallocation of production and consumption will be according to the law of comparative advantage.  In other words, trading countries will be better off, because greater specialization in each country's area of comparative advantage raises total output from a given level of resources.  Some workers will have to change jobs, and perhaps even change locations, but, after initial frictions, they will be moving into areas of comparative advantage.  But this should be a topic for later.

Sum up please, my brain hurts.

Okay.  Talking heads who call for a strong dollar without saying how they propose to bring that about are implicitly assuming that capital inflows will increase enough that the current account deficit doesn't have to shrink.  The most likely and least painful route to that outcome is for the dollar to continue declining until it raises expectations of investors that it's bound for a rebound.  We may be near that point for all I know.  Or not!

If we aren't on the verge of renewed strength in capital inflows, we have to accept the internal adjustments necessary to shrink the deficit.  Those internal adjustments can most painlessly be triggered by further declines in the dollar that raises the prices of imports to us and lowers the price of our exports to out trading partners.  If we somehow prevent further dollar depreciation, the incentives for the necessary resource reallocation will involve domestic disinflation, deflation, and possibly recession.  Not a better alternative.  Worst still is the option of restricting trade.  This is why I've said publicly several times that while I like a strong dollar, by Jingo, a weaker dollar may be the least-worst way of dealing with our foreign imbalances.

Now my head hurts too

I don't feel finished with this important topic, but I have joined the ranks of my few gentle readers who've enjoyed about as much of it as they can stand.  Maybe more later.