Down With the Dollar

Dean Baker
The Guardian Unlimited, November 5, 2007

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In recent weeks, the dollar has been plummeting in value relative to the euro, the British Pound, and other major currencies. This continues a decline that began six years ago. Since 2001, the dollar has lost 30.0 percent of its value against the British pound, 39.5 percent of its value against the euro, and 41.5 percent of its value against the Canadian dollar, which now sells for 1.07 U.S. dollars.

The decline in the dollar is leading to a bit of a panic in some circles. For example, the New York Times has published at least two editorials decrying the falling dollar and blaming President Bush’s tax cuts. Last week, Robert Rubin, who was Treasury Secretary in the Clinton administration and a major proponent of a strong dollar, warned that the falling dollar would lead to higher inflation and a lower standard of living. Many others have expressed similar concerns.

These rants might be humorous if there was not a danger that they could affect policy. Therefore we must stop laughing at the United States’ leading newspaper and our former Treasury Secretary and carefully explain why the dollar is falling.

The top reason on this list is the U.S. trade deficit. In 2006 the United States imported $2,230 billion worth of goods and services from abroad. It only exported $1,470 billion. The $760 billion gap corresponds to an excess supply of dollars on international currency markets. This large excess supply of dollars puts downward pressure on the dollar in the same way that the excess supply of any product would put downward pressure on its price.

Of course trade is not the only source of demand for dollars. Investors will want dollars insofar as they want to invest in the United States. The foreign funds that bought up those mortgage backed securities which are now going bad had to get dollars to make their purchases. Foreign investors also need dollars if they want to buy stock in U.S. corporations, directly invest in new operations in the United States or buy up government bonds. In addition, foreign central banks, most importantly the Chinese central bank, have been buying up hundreds of billions of dollars of U.S. bonds in a conscious effort to prop up the dollar. This keeps their exports cheap for people in the United States, thereby sustaining their export market.

In the late 90s, the flow into dollars for investment purposes exceeded the outward flow due to the trade deficit, thereby causing the dollar to rise. This rise in the value of the dollar had the positive short-term effects noted by Mr. Rubin: it lowered inflation and raised living standards by making foreign goods cheaper for people in the United States.

However, the high dollar inevitably meant that the trade deficit would expand through time as trade patterns gradually adjusted to changing currency prices. This meant that sustaining the value of the dollar would require ever larger investment flows. While these investment flows did reach enormous levels, it was inevitable that the size of the annual capital inflows would eventually hit a limit.

This limit has now been reached. And with the dollar now falling, investors are increasingly wary about putting their money in dollar denominated investments. If not for the decision of the Chinese central bank to intensify its efforts to prop up the dollar (they are now purchasing more than $40 billion a month by some accounts), the dollar would be falling even more rapidly.

So who is to blame for the falling dollar in this story? The answer is simple: Robert Rubin and the people who let it become over-valued in the first place. The high dollar of the second Clinton administration produced beneficial short-term effects (at least for people who did not have to compete against imports), but had inevitable long-term costs. We are now experiencing these long-term costs in the form of the decline of the dollar, which will lead to higher inflation and quite likely higher interest rates.

In this particular case, President Bush and his tax cuts are innocent bystanders. If anything, the expected effect of his tax cuts should be to raise the value of the dollar because the resulting budget deficits lead to higher interest rates in the United States.

In short when looking for people to blame for the falling dollar, the spotlight should be focused on the people who gave us the high dollar. It was a story of short-term gain for long-term pain, just like the Bush tax cuts, except the impact of the over-valued dollar is considerably larger. 

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, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.