Dollar Confusion

Credits in the U.S. balance of payments give rise to a demand for dollars. Debits reflect the supply of dollars. Together, they determined the exchange rate for the dollar. So far, so good. Everybody knows that.

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

Comments (7)

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  1. Joe Calhoun says:

    Mr. McTeer,

    Twice in my adult life the US has pursued a blatant weak dollar policy. The first was after 1985 when, through the Plaza Accord, we deliberately weakened the dollar in an attempt to cure our persistent trade deficit with Japan. As I’m sure you are aware, it didn’t work although we did manage to cause a stock market crash (at least according to some). The trade deficit did narrow during the ’90 recession but that had little to do with the value of the dollar.

    The second attempt to devalue our way to prosperity was during the recent Bush administration when a series of Treasury Secretaries managed to convey the message that a weaker dollar was okay with them and the US Chamber of Commerce. As you know, that didn’t do much for our trade deficit either, this time with China, although we did manage once again to crash the stock market. Deja vu all over again as Yogi once said. Yeah, I know, correlation, causation and so forth, but I’m 48 years old and every time we’ve let the dollar fall in a major way, it has meant an economic mess. From my viewpoint, that isn’t coincidental.

    Now, I am not one of those who believes that a strong dollar ipso facto means a strong economy. It is good policy that produces a strong economy and therefore a strong currency. Actually what we should all want is not a strong dollar or a weak dollar but a stable dollar. The problem with a fluctuating dollar is that it plays havoc with economic calculation, especially in a globalized economy. But I digress…

    So, my question is this: if good policy produces a stronger dollar and bad policy produces a weaker dollar, shouldn’t we be aiming for the former rather than the latter? How exactly can bad policy pursued for a limited time produce a positive economic result?

  2. Bob McTeer says:

    If policy is good at combating inflation, it would produce a stronger dollar. If policy is good fighting to get out of a deep recession, it probably would produce a weaker dollar. You have to know the goal.

    I agree with you about the stable dollar. I generally find that many who argue for a strong dollar, when you discuss it with them, actually are talking more about a stable dollar than a strong dollar. I agree with that.

    Yes I remember the Plaza Accord. The graph of the dollar peaked that that point and came straight back down. Looked like the Grand Tetons.

    Thanks for your comment.


  3. LS says:

    I generally agree with Mr. McTeer’s analysis, but rather than viewing this in terms of producers vs. consumers, I would would view this in terms of long-term vs. short-term benefits to the economy.

    Weak dollar policies (e.g. inflationary policies) keep US companies competitive when the only basis for competition is price. Strong dollar policies force US companies to develop competitive advantages other than price.

    The result of a strong dollar policy is often Schumpeter’s “Creative Destruction.” Companies that compete only on the basis of price in a strong-dollar environment eventually go out of business and are replaced with companies that compete by providing something their overseas competitors do not or cannot. They develop competitive advantages based on something other than price. This is innovation.

    Weak dollar policies enable job growth/retention in non-innovative commodity markets and drive up prices for consumers. In the end, weak dollar policies yield similar results to protectionist tariffs. They protect jobs (good for the short-term), but prevent us from experiencing the benefits of creative destruction (bad for the long-term.)

  4. EHROSEN says:

    Question for Mr. McTeer:
    I was intrigued by your aside in the article where you mentioned that you were not one of those who favored pressuring China to revalue the Yuan in the past.
    What was the reasoning behind your reluctance?
    If China were to revalue the Yuan today, what effect would it have on the US economy, stock and bond markets?
    Is this an example, do you feel, of “be careful what you wish for?”.
    Your pieces are spectacular for those of us who want to understand and simply can not find this information anywhere else in a reasonably digestible form.
    Thank you for your help.

  5. Bob McTeer says:


    Re pressuring China to revalue the yuan, there are several reasons:

    1. Even though we share the exchange as we do all bilateral exchange rate, the tradition is for other countries to peg to the dollar, not the other way around. This is left over from the days when our committment was to peg to gold while others pegged to the dollar.

    2. China is a proud country and the more pressure we put on them (especially publicly) to do something the more they resist lest they be regarded as caving in to our pressure. The probability of success is greater the less posturing we do publicly.

    3. In my last visit, in all of several speeches and interviews, I emphasized that the decision was China’s to make (even though we do share the rate), I pointed out that they were subsidizing America’s poor people (WallMart shoppers) at the expense of their own poor.

    4. We don’t hear much about it these days, and they may have slowed down during the crisis, but they were allowing the yuan to move up slowly (a controlled peg). They were moving in the right direction at a slow pace, but over time it made a difference.

    Thanks for you comment and question.


  6. Mark Packard says:

    A great read, very well thought out.

    One argument I would make (in resonse to LS) is that, while a weak dollar creates a surge in foreign demand, it is NOT wise to give government or the Fed power to weaken the dollar through artificial methods such as inflation.

    The weakening of the dollar in a recession is caused by foreign demand for the dollar declining, as Mr. McTeer indicated. If we pursue further currency weakening policies, the market balance is again thrown off by overcompensation.

    We don’t WANT to weaken the dollar. When exports exceed imports, we lose value nationally. We have to pay (export) more for the foreign products (imports) we want. But, as indicated, a weakened dollar in a recessed economy is necessary in its rebalance, and shouldn’t be considered apocalyptic. But let the market do the balancing.

  7. Lizzy Cork says:

    I hope the government will do good in providing more ways to increase the value of the dollar. I guess there should be more available jobs for unemployed just like what the bigjobsboard has been doing.