Commentary

Deflation and Devaluation

This article was published in the Washington Times, June 1, 2003.

Everyone is talking about dollar devaluation and deflation, which is certainly an odd couple. If there was any reason to worry about the dollar going down (devaluation), it might be that a weaker dollar makes it easier for prices to go up. If there was any reason to worry about prices going down (deflation), that anxiety should have vanished long before the dollar had fallen for 15 months. Yet New York Times columnist Paul Krugman is still worrying about a Japan-style deflationary “quagmire.”

The only reason the 1997-2002 deflation scare still sells papers is that the word was dropped by the Fed in early May and the International Monetary Fund more recently. Given the forecasting record of the IMF, Fed and Mr. Krugman, when they start worrying about deflation, investors start betting on inflation. An executive at TIAA-CREF tells me their most popular fund is inflation-protected bonds, and gold is up about 16 percent over the past year. Deflation scares for the United States are quagmire quackery, as I explained with greater patience in a column last November.

There are also those who worry about the dollar. A lady on PBS with a classy British accent was recently pontificating about the dangers of a falling dollar. If we let the dollar fall too quickly, she warned, foreigners will stop investing in the United States, making it impossible to finance our current account (trade) deficit. She said the Fed will then be forced to push interest rates up to defend the dollar (crashing U.S. stock and bond markets is supposed to make the dollar more valuable), and that could create recession.

This is the old “hard landing” hoax that Keynesians recycle each time the dollar momentarily stops rising. That doesn’t happen often. The Fed’s trade-weighted index for the dollar has been about 118 lately, which is where it was from July 1998 through July 2000. Pundits say Treasury Secretary John Snow has abandoned the “strong dollar” policy, yet the dollar is just as strong as it was when we supposedly had a strong dollar policy. The dollar rose before and during the last recession, but that does not constitute a persuasive case for a rising dollar. Strong means stable, not rising. For perspective, the Fed’s dollar index was 35 in early 1981, when President Reagan took office.

Why should a drop of the dollar against the euro make Europeans stop investing in the United States? Suppose the dollar drops by 20 percent against the euro. That does not just make U.S. goods look 20 percent cheaper to Europeans, it also makes U.S. stocks, bonds and real estate look 20 percent cheaper.

Why should a bargain like that make Europeans stop investing in the United States? The lady on PBS suggested that the fact the dollar has fallen in the past makes foreigners fear it will fall more in the future. That makes as much sense as saying tech stocks were a terrific bargain in March 2000 because they had gone up so far and so fast. In reality, smart European investors have probably been helping to bid up U.S. stock prices.

Foreigners could stop investing in the United States only if they were willing to either buy more U.S. goods and services or sell us fewer of theirs. So long as any country runs a trade surplus with the United States, that country’s exporters are going to end up accumulating more dollars. Those dollars can only be used to buy U.S. goods or assets. A journalist recently said there’s a third choice — to trade spare dollars for foreign currencies. But whoever buys dollars for euros still has only two choices, to spend or invest the dollars in the United States. Sellers of euros may offer more of them for fewer dollars, but the buyer and seller in a foreign exchange deal cannot both gain from that trade.

So forget about deflation and hard landings. There are real things to worry about, like the endless East Coast rain.

The positive spin on the dollar’s modest reversion to the pre-recession level is that a cheaper dollar means cheaper exports and more costly imports. But that depends on what happens to prices, including prices (costs) of imported materials.

Suppose comparable French and California wines used to sell for $10 in the United States and 10 euros in France. What happens if the euro rises from 1 to 1.20 per dollar? If the French wine merchant lifts his price to $12, sales in the United States will suffer. If California leaves the price at $10, it might export more wine to France (national pride aside).

In the real world, the French wine might just rise to $11, with those involved in producing and distributing that wine forced to cut costs or take a smaller profit. This is no more deflationary for France than it is inflationary for the United States — unless the dollar keeps sliding — because it is just a one-time price adjustment. If French wine rose to $11, though, California wine producers and merchants could safely raise their prices too without losing market share.

This is what people mean when they describe a lower dollar as a supposedly welcome remedy for “deflation.” They mean dollar prices of traded goods are more likely to rise when the dollar falls.

Will such extra pricing power be good for the United States? That depends on whether you are buying or selling. Producers enjoy more elbow room to raise prices; consumers prefer bargains. Even producers have to buy materials and machines, so they don’t want those prices to go up. They want selling prices to go up faster than costs. But a weaker dollar does not necessarily do that.

Most imported raw materials, notably oil, are priced and traded in dollars on the world commodity market. If the dollar drops 20 percent against the euro, an unchanged oil price would look 20 percent cheaper to a European company. Europe might well respond by stockpiling more oil, which could push the oil price up in dollars. The same is true of other commodities, some of which are mainly produced in the United States and some not.

Over the year ending May 20, the Economist’s index of commodity prices fell 11 percent when measured in euros but rose 13 percent in dollars. It’s not at all clear whether that is good news or bad, or whether it is better news for the United States than for Europe. Higher commodity prices are revenue for commodity producers and a cost for users. What is clear is that to worry about both a lower dollar and deflation is inconsistent at best, like complaining about drought and the incessant rainfall. Worry less, and study more.

Alan Reynolds is a senior fellow with the Cato Institute.