Should We Have A Strong Dollar Policy?
Friday, April 4th, 2008
The starting point for the troubles that plagued the financial markets from 2007 into 2008 was the sharp decline in confidence in the value of sub-prime mortgages, and securities backed by mortgages. Poor mortgage underwriting on the part of lenders, poor due diligence on the part of borrowers, and greed on the part of both, and inadequate assessments of risk all contributed to this. One focal point for the fallout from this was the failure of Bear Stearns in March of 2008, and the Federal Reserve’s bailout of this investment bank coupled with the purchase of Bear Stearns by JP Morgan Chase. The Federal Reserve’s bailout of Bear Stearns will inevitably result in an increase in the money supply, resulting in more dollars appearing in the foreign exchange markets and a weaker dollar. On top of the above are significant declines in the Federal Funds rate, volatility in the financial markets, and debate related to the strength of the economy in the United States. All of this is known, but the value of the dollar is also an important factor that underlies the important issues facing the economy in the United States.
The weaker dollar is primarily the result of continuous large trade deficits on the part of the United States. Declining confidence on the part of foreign investors that they will earn an appropriate return on their investment in the dollar denominated investments given the risk they are assuming is also a factor. Low interest rates in the United States exacerbate this because it drives investors to look elsewhere for higher returns. In other words, when the Federal Reserve undergoes a process of expansionary monetary policy to support the financial markets and stabilize the economy the lower interest rates that result weaken the value of the dollar. Inflation pressures in the United States due to higher energy and fuel prices, and the expectation that inflation pressures will only increase also contribute to the weaker dollar. Yet, the weaker dollar contributes to higher oil prices since the price of oil is denominated in dollars, and also results in a decrease in demand for dollar denominated securities. It also adversely affects those countries that depend on the dollar as a medium of exchange and a store of value. Countries in Asia, South America, and the Middle East are all affected.
Despite this positives related to the weaker dollar can be identified. It stimulates demand for U.S. exports and this has helped provide a stronger base under the U.S. economy. Furthermore, it highlights unsustainable large trade surpluses on the part of the economies in Asia indicating possible inflation pressures in countries like China. Furthermore, the trade surpluses enjoyed by China result in an accumulation of dollars and dollar denominated assets, and if the return on these assets are low enough it will become more practical for the Chinese to invest at home stimulating demand for goods and services, including the goods and services made in the U.S. Yes, this can also be a source of inflation for China, but investments in education, infrastructure, health care, and research and development are very productive uses of funds. All of this appears to be positive, but that is a hard sell to owners of dollar denominated assets, and as alluded to above, a weaker dollar fuels higher prices for commodities including oil and grain. It can be argued that the positive aspects of a weaker dollar in that it stimulates exports just masks the impact of long-term structural problems affecting the U.S. economy; increasing amounts of private and public debt and inadequate investment in education, infrastructure, health care, and research and development.
This raises a question; what would happen if the policy was to promote and maintain a strong dollar? It would lead to higher interest rates in the short-run as the only way to effectuate this in a short period of time is to remove dollars from the currency and money markets. These higher interest rates would result in lower levels of consumption and investment, including investment in real estate, and potentially economic recession. In the longer run, though, the higher interest rates would result in additional savings which facilitates investment, and stability in the money and financial markets. Households would have to think longer term rather than rely on debt to meet their needs. Among the forms of investment that can be facilitated is investment in the initiatives I listed above that increase productivity. Of course, though, what happens between the short-run and the long-run indicated in this paragraph? The recession that may result might be deeper and last longer than expected. Then again, if you believe that an economic realignment is warranted based on the troubles affecting the economy, then history shows that delay will result in only a deeper hole to dig out of. This is only one of several possible scenarios and that is the immediate problem with the economy.