Devaluationist Bunk

This article appeared in the February 25, 2008, issue of Forbes magazine.

The Federal Reserve dramatically slashes both the federal funds target rate and discount rate twice inlittle more than a week, confirming that the centralbank has thrown inflation fighting to the winds. Theinterest rate reductions also confirm the Bush Administration's(and the Fed's) cheap-dollar policy.

While this is bad news for inflation hawks, it's a delightfuldevelopment for people who think the government should manageinternational trade. They believe that the U.S. trade and broadercurrent account deficits reflect America's lack of competitivenessand are inherently bad. According to this thinking, a dollar devaluationis virtuous because it makes U.S. goods more attractive. Suchthinking is common, even among some economists. It's bunk.

Just consider the most recent bout of dollar weakness. The tradeweightedvalue of the greenback has fallen 21% since 2001. So didthis weakness in the currency create prosperity or even shrink thetrade deficit? No. Since 2001 exports increased 78%, but importsincreased even more, 85%. This left the trade deficit twice as largein the third quarter of 2007 as it was in the last quarter of 2001.

To appreciate just how ingrained the devaluationist bunk is, goback to 1971. That year Richard Nixon abandoned the Bretton Woodssystem of fixed exchange rates. He closed the gold window, imposeda surcharge on manufactured imports and demanded that other bigindustrial countries allow their currencies to appreciate against thedollar before he would remove the surcharge. They all did, leavinga foreign exchange system of 22 years' duration in tatters and givingthe cheap-dollar mantra a comfortable home in Washington, D.C.

Did the Nixon cheap-dollar policy make exports grow fasterthan imports? Scarcely. The U.S. trade deficit has been in negativeterritory every year since 1975.

Nothing better demonstrates the impotency of devaluationsin creating a trade surplus than the U.S.-Japan story. Starting withthe Nixon Administration, the U.S. has pursued a two-prongedstrategy: protectionist threats coupled with demands for a yenappreciation (that is to say, a cheaper dollar). Amid this madnessthere have been some intervalsof lucidity. The first ReaganAdministration (1981-84) andthe Clinton Administration (after April 1995) embraced a strongdollarpolicy. The trend, though, is in line with the mercantilistview that dollar weakness is something to be sought after. Since1971 the yen has appreciated 240% from its Bretton Woods value(360 to the dollar) to its value today (106 to the dollar).

According to the devaluationists, that cheapening of the dollaragainst the yen should have worked wonders on the U.S. trade deficitand in particular on the two-way trade deficit with Japan. That didn'thappen.

The U.S. trade deficit not only kept growing, but Japan's contributionto it ballooned from 26% in 1977 to 58% in 1991. (In 2000China overtook Japan asthe largest contributor tothe deficit. Now Japan accountsfor only 11%.)

With the U.S. tradedeficit continuing to pose a "problem," both the Bush Administrationand the Fed turned to that old discredited antidote, a cheap dollar.The main thing that has changed since the early 1990s is that the deficit has become bigger inabsolute and relative terms, andChina has replaced Japan as thetarget of protectionist wrath. Willthe current cheap-dollar ploychange the U.S. trade and currentaccount picture? No.

Truths in economics boildown to accounting principles,as immutable as the laws ofphysics. Our current accountdeficit is equal to the sum of twoquantities: the excess of privateinvestment over savings and thegovernment deficit.

The last ten years can be divided into three periods. In the late1990s the public sector was in surplus, and the current account deficitwas the result of an investment boom coupled with a savings drought.

With the end of the dot-com surge in 2000, the private sector'scontribution to the current account deficit shrank. But the slackwas more than made up by the government's spendthrift habits.By late 2003 the real estate boom had kicked in, and both theprivate investment-savings gaps and government shortfalls werecontributing mightily to current account deficits.

Trade imbalances are all about net-savings propensities, notchanges in exchange rates. As the coming recession gathers force,the private investment rate will slow and the savings rate willincrease, closing the investment-savings gap. At the same time,government deficits will probably creep up.

On balance the current account deficit may well ease a bit.Unfortunately, however, this development won't stop the irrationalagitation for a cheap dollar.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Cato Institute in Washington, D.C.