Commentary

Perspective: Dollar Disorientation Affects Even Conservative Analysts

This article originally appeared in Investor’s Business Daily on December 3, 2004.
Proponents of good and bad policy changes are once again trying to hitch their wagons to the dollar.

The editor of ConservativeBattleline, Don Devine, writes that “entitlements (Social Security and Medicare) must be restrained if confidence is to be restored in the dollar.” Does he think the euro is up because Europe is shrinking the welfare state.

Conservative columnist Bruce Bartlett likewise found the dollar a handy new rationale for his year-old prediction of “a significant tax increase..

Devine was impressed that Japan’s prime minister “bluntly told Bush he must deal with American twin deficits in government spending and trade to stabilize the currency.” He failed to notice the irony of a Japanese official lecturing an American about budget deficits.

The U.S. budget deficit is 3.7% of GDP, the same as Germany’s and France’s. Japan’s budget deficit exceeded 6% of GDP for the past five years and is now above 7%. If budget deficits explained trade deficits or interest rates, Japan would have the largest trade deficit and highest interest rates.

Bartlett’s thesis that a smaller budget deficit would strengthen the dollar by shrinking the current account deficit is false. The U.S. dollar has declined as much against the Australian dollar as against the euro, yet Australia’s current account deficit is larger than ours.

Besides, current account deficits are unrelated to budget deficits here or there. The U.S. current account deficit was 0.8% of GDP in 1992, when the budget deficit was 4.7% of GDP. After the budget moved into surplus, the current account ballooned to 2.3% of GDP in 1998, 3.1% in 1999 and 4.2% in 2000.

What about the alleged threat of foreigners rushing to sell dollar assets, driving U.S. interest rates sky-high? If foreigners as a group tried to sell their dollar assets, they would have to sell them to Americans, which would have to be a good deal for us or we wouldn’t do it.

“Japan and China are the two largest holders of U.S. debt,” frets Devine. “If they lost confidence and redirected these obligations, it would cause economic catastrophe..

Yet the value of the dollar reflects the market for all dollar-denominated assets, not just federal debt. And foreigners hold only $1.7 trillion of our $7.3 trillion national debt.

U.S. Treasury securities are held as central bank backing for currencies because they inspire trust. Our own Federal Reserve holds $687 billion. Japan’s central bank holds $720 billion. These reserves, accumulated over many years, are insignificant compared with the global stock of dollar-denominated assets.

Bartlett notes that foreigners invested $829 billion in the U.S. last year alone, with just $249 billion of that accounted for by foreign central banks. The investment by foreign central banks worries him because it “threatens foreign central banks with large capital losses if U.S. interest rates rise..

That is their problem, not ours. But it certainly argues against foreign central banks trying to raise U.S. interest rates by selling Treasury securities. That wouldn’t work anyway. U.S. budget deficits added hundreds of billions to the world supply of Treasuries since 2001, yet interest rates fell to record lows.

Bartlett ends by switching from worrying about financing current account deficits to asserting that “foreigners are tired of financing the U.S. budget deficit.” That is a different subject. We had no budget deficits in 1998-2000, yet central banks added substantially to their dollar reserves.

Bartlett also worries Asian central banks might diversify “into euro-denominated assets” and thinks the U.S. Treasury would then have to “increase the interest rate it pays.” But global bond markets are tightly integrated, with ups and down in U.S. interest rates closely matching euro interest rates.

Bartlett also worries that future declines in the dollar “could lead to a sharp drop in the stock market and a spike in interest rates..

The presumption that a lower dollar must sink stocks is incorrect.

At the end of last year, The Economist reported its measure of the dollar’s value had fallen by 13.8% in 2003, but the U.S. S&P 500 stock index had risen by 26.1% and the Nasdaq by 50.2%.

Far from repelling foreign investors, a lower dollar makes U.S. assets a bargain in euro or yen. Foreign bargain-hunting tends to drive U.S. stock and bond prices higher in dollars.

The Fed’s broad, trade-weighted index of the dollar’s value sets January 1997 equal to 100. In November, that index was at 110.36, which is clearly up since 1997 despite being down from its peak in July 2001. But July 2001 is a bizarre date to set up as an ideal benchmark, since the economy was in recession. China accounts for only 12% of our imports, by the way, and its weight in the index is only about half that large.

The broad dollar index has risen almost continuously since July 1973, when it was 30.6. The only previous big decline was between March 1985 (69.2) and December 1987 (58.7). Ominous predictions that the dollar was about to fall precipitously were commonplace at the end of 1987, but the dollar instead started rising and didn’t stop until 2001. Could that happen again? It usually does.

Bartlett nonetheless warns: “A further fall of the dollar … will raise the prices we pay for foreign goods. This will boost inflation..

The dollar has been falling for 3 1/2 years, so where’s the inflation.

The Bureau of Labor Statistics keeps a price index of imported goods, with the year 2000 equal to 100. In October, the price index for crude oil was at 150.9. But the price index for all other imports was only 99.8 — up 2.8% from a year earlier, yet lower than 2000. Aside from cars (102.6), the price index for consumer goods was only 98.4.

The Economist’s index of sensitive commodity prices was 88.6 on Nov. 23 when measured in dollars — 2.4% higher than a year ago, but still substantially lower than that index’s base year, 1995, when the index was 100.

In euros, the same index is now 89 — about the same as the U.S., but down 7.8% from a year ago. In yen, the index is 97.4, down 3.5% from a year ago but still much higher than the U.S. The rising euro and yen appear deflationary in Europe and Japan, rather than inflationary in the U.S., but the long-run trend is toward convergence.

Over the past year, however, consumer prices were flat in Japan, up 2.4% in the euro area and up 3.2% in the U.S. That suggests monetary policy should be tightened in the U.S., but not in Europe or Japan. If that happened, the dollar would likely rise. The budget deficit is irrelevant.

Just remember that foreigners who export to the U.S. are paid in dollars that have to be either spent or invested here. If foreign exporters refused to invest or spend those dollars, then we would have their goods and they would have nothing in exchange.

There are doubtless many things worth worrying about, but the old “twin deficits” and “hard landing” theme that a budget deficit leads to trade deficits and hence to some ill-defined catastrophe is not one of them.

Alan Reynolds is a senior fellow with the Cato Institute.