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Challenging Group Thinking Economists on Budget Deficits and the Dollar

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Dean Baker
TPM Café (Talking Points Memo), December 28, 2008

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Virtually the whole economics profession somehow managed to overlook the largest housing bubble in the history of the world. Remarkably, few, if any, economists were fired or even demoted for their extraordinary incompetence. Unlike dishwashers and factory workers, economists are not held accountable for their performance.

This is disturbing not only for its moral implications, but more importantly because the lack of accountability means that economists have no incentive to ever start thinking for themselves rather than just repeating the conventional wisdom in the profession. After saying silly things about the housing market for much of the last decade, the same crew is now saying equally silly things about the value of the dollar and the budget deficit.

The housing bubble deniers are now warning that large budget deficits could send the dollar plummeting. These warnings stem from the same of sort of failure to understand basic economics that caused most economists to miss the housing bubble. The dollar will undoubtedly fall at some point in the not very distant future, but the reason is not the budget deficit, the reason is the trade deficit.

The logic is very simple. The value of the dollar declines against other currencies when the supply of dollars on international markets exceeds demand. The budget deficit does not directly put dollars on international markets. It simply means that the U.S. government must borrow to make up the gap between its spending and its revenue. This borrowing can be met by printing money (the Fed buys government bonds) or by borrowing in private credit markets.

Printing money will have no direct effect on the value of the dollar in international currency markets. It should help keep interest rates in the U.S. lower than they would be if the Fed didn't print money, but that doesn't mean that the dollar will necessarily fall in value. Japan's central bank printed enormous amounts of money over the last decade yet its main concern is that the yen is rising in value.

If the government borrows in credit markets, then this should raise interest rates, which would more likely raise than lower the value of the dollar. The basic story is that at higher interest rates, investors will want to hold more U.S. financial assets. This will increase the demand for dollars in international currency markets, putting upward pressure on the value of the dollar. (Economists used this story in the 80s to explain how the budget deficits of that era lead to the trade deficit. Unfortunately, few economists seem to remember the conventional wisdom from 15 years ago.)

In short, the economists who claim that the large budget deficits will lead to a fall in the value of the dollar have no more of clue than when they were denying the existence of a housing bubble two or three years ago.

Of course the dollar will fall, but this would be the case even if the U.S. were running a budget surplus. The reason is that we are running a large trade deficit and have been for some time. With a trade deficit between $600 billion and $700 billion (4-5 percent of GDP), we are throwing hundreds of billions of dollars on world currency markets each year.

In the past, foreign central banks (most importantly China's) had bought up dollars in an effort to keep down the value of the currency and thereby sustain their export market in the United States. Since they have gotten a very low return on a currency (the dollar) that has been declining in value, these central banks are effectively paying people in the United States to buy their country's output.

It is unlikely that foreign central banks will continue to buy up large amounts of dollars indefinitely, since they can actually pay anyone to buy their stuff, including their own people. When foreign central banks stop subsidizing their exports to the United States, the dollar will fall to a level that will bring its trade deficit more closely into balance.

In the end, the dollar will fall, but the reason is that the dollar was too high. The decision to run a high dollar policy by Robert Rubin in the late 90s helped to create the imbalances that lay behind both the stock and housing bubble. It was a short-term policy that must inevitably be reversed.

While the conventional wisdom in the economics profession may attribute the eventual fall in the dollar to the budget deficit, economists who think for a living know that the key problem was an over-valued dollar. The country has relied on the conventional wisdom among economists long enough.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.