RateWatch #437 The Dollar - Declining by Design?

December 11, 2004 by Dick Lepre

The Dollar - Declining by Design?

This is both an addendum to last week's "The Twin Deficits" and, since this piece was done a year ago, support for the proposition that the decline in the value of the dollar has been by design.

The dollar has recently been at a record low v the Euro. What's up? Is this a disaster for the U.S.
economy? Don't people want dollars anymore? Are we doomed?

The dollar is being driven down because the Fed wants it down. If you go back a year ago it was
obvious that the dollar was overvalued. This had the effect of hurting U.S. exports (expensive
dollar = pricier U.S. goods).  Part of stimulating the economy was to make domestic goods more
attractive (price-wise) than imported goods. That necessitated a falling dollar.

In fact, part of the Fed's plan in keeping rates low was that it drove down the value of the dollar
because foreigners are less likely to invest in U.S. fixed income assets when the yields are
so low.

To some extent, part of the economic recovery has been at the expense of the dollar.  The open
question is whether or not foreign central banks will buy Treasury securities at the present yields
without being convinced that the dollar will stop losing value.

The fact that the U.S. has been a debtor nation since 1986 and so much of our debt is foreign-owned makes some folks very nervous.

Adam Smith wrote that nothing can be more absurd than this whole doctrine of the balance of trade. Concerns about the trade deficit hurting the economy are ill-founded.

The underlying notion that a trade deficit is bad and a trade surplus is good has not been
supported by the facts.  Japan has been in recession for a decade despite large trade surpluses.

Trade deficits are not determined by the microeconomics of trade policy or by competitiveness. They reflect underlying macroeconomic factors: investment flows and the national rates of savings. Americans do not put their money in the bank they put it in the (stock) market.  Japan, for example, has a higher savings rate and it is natural that some of that makes its way
here as investments.  China, as of late, has a large trade surplus and that also turns into
investments in the U.S.  In some way, that also acts as a deterrent to possible military conflict.
Investment in another country's assets are a good reason to not attack them.

For the most part, the trade deficit is what is properly called a "current account deficit" and
it is offset by a "capital account surplus".  In simple terms we buy more "stuff" that we export
and foreigners buy more U.S. assets: bonds, real estate etc. than we buy foreign bonds and real

The trade deficit is neither inherently good or bad.  It represents the present state of economic

The concern about the falling dollar is fine. We should be concerned about the value of the
dollar but we must also recognize that the current fall in the value of the dollar is
entirely by design.  It was regarded that the U.S. economy needed stimulation (GDP growth
and jobs) and that lowering the value of the dollar would increase exports, decrease imports and increase GDP.

To some extent, this has been achieved.  GDP has jumped and jobs growth is there (albeit slow).
AS Fed continues to increase rates dollars will "suddenly" seem a bit more attractive.

None of this is to imply that this is all easy. the Fed had to lower rates yet somehow keep
Treasury yields attractive enough to attract foreign investments in U.S. fixed-income

The Fed has four main goals: GDP growth, job growth, containment of inflation and a strong
dollar.  Sometimes these goals are at odds with one another.

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