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Home Publications Blogs Beat the Press The Value of the Dollar Does Not Tell Us About the Strength of the U.S. Economy

The Value of the Dollar Does Not Tell Us About the Strength of the U.S. Economy

Thursday, 14 March 2013 13:47

Yes, boys and girls and Arnold Schwarzenegger fans everywhere, a strong dollar does not mean a healthy economy, contrary to what Neil Irwin told us today in the Washington Post. In fact, fans of arithmetic and believers in accounting identities know that an over-valued dollar is at the root of our current economic problems. While believers in the Confidence Fairy think that investment will reach new highs as a share of GDP, and/or consumers will spend even when they have little wealth, those of us who follow data know that the only way to make up the demand shortfall created by trade deficit is with a large budget deficit. However, the Serious People say that we can't have a large budget deficit, so that means we get high unemployment.

The only serious way to get the trade deficit down is get the dollar down. That will make our exports cheaper to people living in other countries and make imports more expensive for people in the United States. That means more exports and fewer imports, and therefore a smaller trade deficit. (For those folks who were looking to the trade agreements, the idea that these will reduce the trade deficit is just something that the Serious People tell to children.)

Anyhow, it is easy to show there is no direct relationship between the health of the economy and the strength of the dollar. In fact, the recovery in the first half of the Clinton administration was based to a substantial extent on the idea that a lower deficit would lead to a lower valued dollar and therefore more net exports. And, this largely worked as shown below.

FRED Graph

Then Robert Rubin took over at Treasury and pushed his high dollar policy giving us record trade deficits along with a stock and housing bubble. You know the rest of the story.

Comments (8)Add Comment
If the correlation doesn't hold...
written by Ashok Rao, March 14, 2013 3:07
In the upward direction, as implied by "Anyhow, it is easy to show there is no direct relationship between the health of the economy and the strength of the dollar", then there's no reason to believe it holds in the downward direction. And if we can't prescribe a policy to revalue the dollar, we certainly can't then to devalue it.

So the best option is to, for use of an unpopular term, let things be, laissez-faire.

I have a more detailed argument here: http://ashokarao.com/2013/03/1...s-it-mean/
Nice cherry-picking
written by Wisdom Seeker, March 14, 2013 3:20
I agree with the previous commenter. For that matter, why do you mention President Clinton here? The devaluation took place from 1985-1992, i.e. before Clinton was elected. The peak dollar on your chart series was in 1985, which anyone with Google can see in a few seconds by getting the full chart from the St. Louis Fed (no wonkishness required): http://research.stlouisfed.org...es/TWEXBPA

Weakest Dollar on record: 2011-Present
written by Wisdom Seeker, March 14, 2013 3:26
Same chart shows dollar currently the weakest on record. How much more does the dollar have to suffer before the "weak dollar" finally normalizes the trade deficit? Or could it be that this metric is not capturing the dollar correctly? Or that the economic theory being discussed here bears no relationship to reality?

Perhaps the way to reduce the trade deficit is to reduce the budget deficit, the corporate profits surplus, and the stealth taxation imposed upon the productive economy by a bloated healthcare sector? There are many terms in the accounting identities that can be rebalanced here...
written by skeptonomist, March 14, 2013 7:55
While it is true that "there is no direct relationship between the health of the economy and the strength of the dollar" (except inflation), there is also not a strict relationship between the value of the dollar and the trade deficit (as I have been pointing out for some time). Not only does the start of the big trade deficit in 1990 not correspond to the start of the higher dollar, the considerable drop in dollar value 2002-2008 apparently did not slow the increase of the trade deficit. This is just more complicated than Dean makes it out to be.

Tariffs can also be used to adjust prices which as Dean correctly says is necessary (but this means inflation for US consumers, which US politicians are probably aware of, if Dean is not). Why exactly would a tariff war be worse than a currency war? Maybe authorities in China are also afraid of tariff wars, and the threat of them could help to force them to change their policies - which involve more than currency manipulation.
written by Chris Engel, March 15, 2013 1:14
It's a bit absurd that people view the Dollar's value as if it's "America's stock" to indicate economic health. But that's something a lot of people push.

There are downsides to a strong dollar in some situations, and there are downsides to a weak dollar in other situations. It depends entirely on the current economic environment.

I think Dr. Baker over time has made a pretty good case for the dollar being overvalued currently, a major driver of the current account deficit.

And to those who say "well the dollar has only gotten stronger/weaker" -- it really depends on relative to what? Half of our trade deficit is driven by CHINA's manipulation of the FX markets with capital controls.

The trade deficit was closed after the 80's due to a decline in the dollar.

The Bush era saw a fluctuation in the dollar, but a major decline in the dollar's value contributed to a peak in the deficit around 2008.

So there are of course a number of variables at work here, but to suggest that the FX value of a country's currency doesn't impact how deep of a deficit they run with imports/exports is just renouncing all theory and empirical evidence around the world evidencing the contrary!

It's worth noting that there are now numerous financial instruments that help firms adjust their FX risk exposure, and that can impact the relationship shown, but it doesn't discount the very real relationship.

And our dollar's status as the world reserve is a major factor in our strong dollar "benign neglect" policy (something that Dr. Baker doesn't like to mention too much, for reasons I don't fully understand, but he has some good suggestions for addressing the concern here: http://www.cepr.net/index.php/...oute-there).

As long as we just refuse to address these imbalances there's going to be a harder adjustment going forward.

The before the second half of the 20th century, the US ran surpluses while Britain ran deficits when they ran the world. The Pound faced a major devaluation during the war and after due to the rise of the dollar.

China's remnimbi is going to be the next dollar -- an overvalued world reserve, and the dollar is going to go the way of the pound in wwII, facing a major readjustment to accomodate a rising power.

There are tons of people who think they're just so smart because the Remnimbi is being manipulated to be too weak for trade purposes, that they will hold Remnimbi and score from what they see as an inevitable strengthening from their running surpluses, but China is engineering a future stronger dollar and weaker Remnimbi in it's future status as a world reserve. TONS of people are going to lose their shirts just like many have tried to call for Japanese bonds crashing and have been screwed on it time and time again.

So the dollar will weaken in an adjustment, but not necessarily against the Remnimbi, where China is going to tactfully engage in an flooding of the market of their currency to legitimize their policy of a weak currency and screw all of the Westerners who think they have an easy trade on RMB-denominated assets.
problem with this prediction
written by paulc156, March 15, 2013 5:13
...problem is that it doesn't always work out. The UK had a massive reduction in its trade weighted exchange value back in 2009 and gained diddly squat in terms of a stronger trade balance. It's now in the process of having another go [since Cameron won't touch fiscal stimulus]and many are expecting similar results.
written by ReturnFreeRisk, March 15, 2013 6:33
Unfortunately, even though your arguments make sense, the data does not support the hypotheses. The dollar has done little to increase exports. It is really the rebalancing of demand that has been the driving force behind pushing trade deficits toward a more sustainable territory. The US can not pull off a S Korea after its crisis in the 90s. Who are we going to export to? Mars? If US wants to triple its exports (like the president laid out), the next 25 big economies have to double their imports. Not happening.
the data do make the case
written by Merius Atangcho, March 17, 2013 8:28
February 8, 2013
U.S. Trade in Goods and Services - Balance of Payments (BOP) Basis
Value in millions of dollars
1960 through 2012

Period Balance Total
1987 -151,684
1988 -114,566
1989 -93,141
1990 -80,864
1991 -31,135
1992 -39,212
1993 -70,311
1994 -98,493
1995 -96,384
1996 -104,065
1997 -108,273
1998 -166,140
1999 -263,160
2000 -376,749
2001 -361,771
2002 -417,432
2003 -490,984
2006 -753,288
2007 -696,728
2008 -698,338
2009 -379,154
2012 -540,362

A nadir was hit right at the point that Dean indicates on his graph (1991) as coinciding with a lower-valued dollar, followed by an explosion in the balance in 1993.

Trade can't just reverse on a dime, so the wild swings from mid-1991 to 1993 can be expected to make for a much less clear picture.

From 1994 to 1995, however, there's a steady decline in the value of the dollar, which coincides with the balance of payments declining over the 1995 period.

After another steady drop in the value of the dollar to a nadir in mid-1995, the balance does not worsen much at all over the 96 and 97 periods. Then comes the East Asian crisis of 1997 and the strong dollar and we see that the balance of payments explodes in the periods after 1997, except for a brief reprieve during the recessions (early 2000s and mid-2000s).

Dean's basic story appears correct and the data show it.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.