Valuing the Dollar

When I was president of the Dallas Fed, Alan Greenspan wouldn't let me, or other members of the Federal Open Market Committee (including himself), talk about the dollar. The dollar was so sacred, or so fragile, that only Treasury secretaries were allowed to discuss it — but convention silenced them too.

Treasury secretaries always retreated into ritualistic claims of having a strong dollar policy to maintain a strong economy, although economic theory doesn't necessarily support that causation. Reporters, presumably for sport and amusement, occasionally lured one of them into the dollar-talk trap, so they could then write about his naïveté for going there.

Now I'd like to say something provocative about the dollar. Here goes: While our currency, the dollar, may be sacred to you and me as an institution — it's ours out there competing with theirs on the world playing field — we shouldn't treat any particular dollar exchange rate as sacred.

A strong dollar usually serves us well, but occasionally, and temporarily, a weaker dollar serves us better. Dollar depreciation boosts our exports relative to imports and, right now, is our best hope for avoiding or cushioning a recession.

I prefer a strong dollar for eternity, but right now I feel about the dollar what St. Augustine felt about chastity. To paraphrase his notorious prayer, "Lord, make our dollar strong, but not just yet."

Currency strength is a more arbitrary concept than most people realize. For example, the Canadian dollar recently reached parity with the U.S. dollar. Parity means they trade one for one, dollar for dollar; yet the Canadian dollar is considered strong and ours weak.

Contrary to most talking heads and Treasury secretaries, strong currencies don't guarantee strong economies, or vice versa. Other things equal, a strong domestic economy stimulates import demand and weakens the home currency, as we have to sell more dollars to buy foreign goods.

The prospect of good investment opportunities at home and future currency appreciation, on the other hand, strengthens the currency by attracting foreign capital, which requires dollar purchases by the foreign investors, even if trade remains in deficit. This has been the U.S. pattern in recent years — a combination of large trade deficits and capital inflows.

The Japanese yen, which had been trading above 110 to the dollar, recently strengthened to below 110. That's relative strength, but when I joined the Fed in 1968, the rate was 360 yen to the dollar. Now that's real yen strength for you — from 360 to 110 — and real dollar weakness. But I wonder if the Japanese benefited from their strong yen and we were harmed by our weak dollar. I'm not so sure.

Current focus is on the strong euro relative to the dollar, but who really believes the strong euro is good for Europe under today's circumstances? The euro zone's unemployment rate has declined to a recent low of 7.2% while the U.S. unemployment rate is 4.8%. While inflexible labor markets are mostly to blame, I wonder what role an overly strong euro and overly tight ECB may have played. The strong euro's cheerleaders may soon feel like the dog that caught the car, if they don't already.

While the dollar may be sacred, no single dollar exchange rate should be. Exchange rates are a compromise among legitimate competing interests.

Consumers benefit from the greater purchasing power of a stronger dollar, and we're all consumers. But our interests as producers and workers are more concentrated. Exporters prefer a weak dollar (i.e., they benefit when foreigners can purchase more of our goods with their strong currency) while importers like it strong. We wisely leave it to the market to achieve the necessary compromise, but a compromise it remains.

Any exchange rate will hurt many market participants through no fault of their own, and give an unearned windfall to others. A good, efficient and productive business that has adjusted well to the prevailing exchange rate may suddenly go belly-up thanks to an adverse exchange-rate movement caused by a completely unrelated development on the other side of the planet. More ethanol production in Iowa may increase hunger in Africa.

The price of one currency in terms of another is a different animal from other market prices. The price of bread adjusts until the quantity of bread demanded equals the quantity supplied at that price. The price may turn against the consumer for various reasons, but mostly having to do with the supply and demand for bread. A market-determined exchange rate also adjusts to clear the market for foreign exchange — but that balance is likely to be a balance of imbalances.

Nevertheless, if a cleanly floating rate remains fairly stable for a while, we label it the appropriate or equilibrium rate and make it the baseline from which future movements are judged to represent strength or weakness.

An ideal equilibrium exchange rate might involve balanced trade in goods and services with the rest of the world. But, with independently motivated capital flows in addition to financing capital flows, there is no economic mechanism to produce that result. Equilibrium can just as easily involve large persistent trade deficits matched by large capital inflows (our situation) or large trade surpluses matched by capital outflows.

A trade balance with the rest of the world would still include huge bilateral imbalances with countries (China) or strategic goods (oil) — but the overall balance would halt the rapid accumulation of dollar assets by surplus countries and keep us from falling deeper into debtor-nation status. To reverse the process would require, not a trade balance, but a surplus. And a stronger dollar any time soon would delay or prevent these needed adjustments.

The late economist, Herb Stein, is famous for saying that, if something is inevitable, it will happen. I assume he meant sooner or later, because the large and growing current account deficit has made dollar depreciation inevitable for years now.

Yet that only recently began to happen because strong capital inflows, especially from Europe, supported the dollar and prevented the depreciation needed to increase exports and bring the trade deficit into balance. We weren't fully paying for our imports with exports of goods and services; so we made up the difference by selling bonds and other assets to strong-currency countries like China.

The accumulation of massive dollar reserves in China led to worry that they would diversify those holdings at some point, a diversification that would involve moving the dollar into other currencies, especially the euro — with such a sell-off depressing the dollar and leading to higher U.S. interest rates. Instead, the diversification so far has been from Treasury securities into private-sector dollar assets. To continue the current account deficit is to continue the fire sale of U.S. assets to foreigners.

My preference would be for dollar depreciation to reduce the current account deficit and slow the accumulation of dollar assets abroad. That process has recently begun. Exports of goods and services in December were up $2.2 billion from November while imports were down by the same amount, more than accounting for the annual December to December improvement in the deficit of only $1.5 billion. Hopefully, that reduction in the trade deficit will continue, but chances are the recent appreciation in the dollar from its lows will slow or halt that improvement.

The level of the dollar is important for trade. But for foreign investors, the level of the dollar is not as important as its expected future movement.

They want to get into U.S. assets when the dollar is cheap and get out when the dollar is dear. The more the dollar depreciates, the sooner it will be expected to reverse, and the sooner foreign investors will resume their participation in the most dynamic, creative economy in the world.

A premature strengthening of the dollar would slow needed trade adjustment and neutralize foreign trade as a source of domestic demand as we try to avoid a severe recession. Once again, Lord make our dollar strong, but not just yet.