Dollars and Sense

Who is harmed by the decline in the dollar?

As consumers, we are all harmed by the decline in our purchasing power.  Import prices go up directly, as everybody knows, but there is also an indirect increase in the prices of domestic goods and services that are also exported or potentially exported.  In addition, some of us are hurt as producers or workers:  people in the import business (foreign car dealerships for example).

Who is helped by the decline in the dollar?

Producers who are exporters or potential exporters at the more favorable exchange rate will experience an increased demand for their products.  Also helped are domestic producers who compete with imports, which will become more expensive.

Why is the dollar declining?  What is the problem?

The dollar is declining because of pressures on our balance of payments.  Some combination of our current account deficit being too big and creating an excess supply of dollars on the world market and our capital inflow (and demand for dollars) becoming inadequate to offset the deficit.

So, what is the relationship between our balance of payments and the market for dollars?

I'm glad you asked that since the connection between the two is key to understanding either one of them.  When we import goods and services or purchase foreign stocks or bonds, or real estate, those transactions are debits in our balance of payments.  When foreigners do those things, they are credits in our balance of payments.  Debits give rise to a supply of dollars and demand for foreign currencies.  Credits give rise to a supply of foreign currencies and a demand for dollars.  To a great extent these debits and credits balance out and so does the demand and supply of dollars and foreign exchange.  So, essentially we pay for our imports with our exports as do our trading partners.  However, it is unlikely that the balance will be perfect; so, there will likely be a small imbalance in trade that will be "financed" or offset by an equal imbalance in capital flows.  I just lost you with that last sentence; so, let me elaborate.

How is it that net trade balances and capital flows are exact mirror images of each other?

When I buy a BMW, I give the company a check on my bank.  If they deposit my check in their U.S. bank and leave the proceeds there, they have "loaned" money to a U.S. bank, which will be recorded as a capital inflow. Their increased bank balance is a capital inflow (credit in our B/P) that just matched my import purchase (debit in our B/P).  They may sell their U.S. dollar balances in the foreign exchange market for a Euro balance in a German bank in which case our dollar obligation is to a foreign bank instead of a foreign company, but the capital inflow remains the same and equal to the BMW import. You don't have to follow all that; just remember this basic point:  Every increase in our debits (from imports) is matched either by an increase in credits elsewhere in the B/P or by an offsetting reduction in debits elsewhere.  Double-entry bookkeeping keeps total debits and credits in balance as well as the dollars bought and dollars sold in the foreign exchange markets.  The balance of payments always balances.  Thus any net deficit or surplus in the trade portion of the B/P is always precisely matched by the opposite in the capital portion of the B/P.

So, what was the background to the recent decline in the dollar?

For several years we have had a large and growing deficit in our trade (goods) balance and our current account (goods, services, unilateral transfers) balance. It grew to more than 6 percent of our GDP, a very large imbalance in trade.  By itself this was supplying excess dollars in the foreign exchange markets.  By "excess" I mean more dollars that were being used to buy U.S. goods and services.  The current account deficit and the associated excess dollars were offset by an equally large capital inflow (surplus) which "mopped up" the excess dollars.

For years a huge trade deficit seemed unsustainable to most U.S. economists and for years they forecasted a decline in the dollar to correct the trade imbalance.  Another way of saying that is to say they didn't think the outside world (especially Europe) would continue lending us large amounts of money to finance our huge trade imbalance.  But year after year those forecasts never came true.  Finally, economists threw in the towel and stopped talking much about it.  (A watched pot never boils.)

Over the past year the U.S. growth has slowed largely in response to the housing situation while the world economy, even including Europe, became more robust.  As we ceased, at least temporarily, being the engine of world growth and as prospects here dimmed relative to prospects abroad, the capital inflow in combination with what was going on in trade became inadequate to sustain the dollar at past high levels.  Theoretically, the dollar will continue adjusting to bring our balance of payments into an internal balance consistent with world economic realities.  That doesn't necessarily mean until our trade becomes balanced, but it probably does mean that the deficit will be reduced.  That process has already begun modestly as our monthly trade statistics have improved of late.

What is the big picture of what's going on with our B/P and the dollar?

Like a family during the process of running up their credit card balances, our large current account deficit means we have been living beyond our means as a country.  We have been absorbing (consuming, investing, etc.) more goods and services than we have been producing. This isn't necessarily bad — you can use a credit card for worthy purposes — but it probably was unsustainable and it is the opposite of what one would expect of the world's richest large economy.  The "normal" pattern is for capital to flow from rich countries to poor countries, where presumably its return is greater.  The reverse has been happening.  Capital has moved to the richest country from poorer countries, presumably because our institutions and policies compared to our trading partners more than offset other factors.

What has to happen for "equilibrium" to be reached?

Our exports need to rise relative to our imports.  Resources will need to move from other industries into export industries.  The declining dollar will provide the needed price incentives by making our imports more expensive at home and our exports less expensive in foreign currencies.  Another way of saying that is that the exchange rate will raise the price of traded goods relative to the price of non-traded goods.

Is there an alternative to a declining dollar?

Yes, but they probably would involve more friction and more pain.  If the dollar is somehow prevented from falling, the needed adjustments would be the same in terms of exports needing to grow relative to imports, or imports needing to shrink relative to exports.  But with no change in the exchange rate, downward pressure on domestic income would push down domestic goods prices relative to international traded goods.  Our imports would have to shrink not because of higher import prices, but because of lower domestic incomes. If internal prices and wages were as flexible as the exchange rate, it would make little difference which is used.  But internal prices, and especially wages, tend to be sticky in a downward direction, so unemployment would be the likely result.  In effect a recession would be needed.

With inflexible exchange rates the temptation would be very strong to avoid the internal adjustments by restricting trade.  Our free trade policy would be in jeopardy.

So, McTeer, are you "dissing the dollar?"

I'm saying that, if adjustment is necessary, a decline in the dollar is probably the least-worst way of achieving it — less worse than domestic recession and less worse than trade restrictions.

Of course, an alternative might be to prolong the status quo ante by reinforcing the factors that made us a strong magnet for foreign capital despite being the most developed of the developed countries.  We could become more business friendly and attract capital keeping the tax cuts we already have and cutting capital gains and dividends taxes to zero, drastically reducing business taxes, etc.  This would postpone painful adjustments, but probably not forever.  However, those policies are needed on purely domestic grounds as well.

Aren't policymakers, especially the Federal Reserve, charged with protecting the value of the dollar?

Yes, but that commitment has always been understood to mean protecting its purchasing power over goods and services not over foreign currencies.  Even with the higher import prices coming from dollar depreciation, overall price indexes can be held down.  Of course, to the extent that a stronger dollar could limit the pressure on import prices, the rest of the job would be easier.

What do you expect our policymakers to do about the dollar?

They will continue to pay lip service to a strong-dollar policy, but deep down they will be grateful that the market is taking care of a potentially more difficult problem for them.  They know they will be criticized later for presiding over a shameful dollar decline, but they are less likely to be criticized for a prolonged recession or a reversal of our free trade policy.  And they will console themselves with the fact that if Congress would just listen to them we could have greater prosperity today and for years to come and leave correction of the trade deficit for a future generation of policymakers.

Comments (5)

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  1. Don says:

    How do you see the decline of the dollar against the canadian dollar and mexican peso as an opportunity for an “amero” (euro) scenario? How do you see our major source of oil being Canada (vs the middle east) and a unified currency between us and Canada being a plan?

    Any more insights (of yours) on the euro that I might find, since the last in 2000?

    Thanks for your thoughts. Economics was my major, though I ended up in a small business. I am with you on the limited role that government and “committees” should have in any economy.

    D Arnts

  2. Norman says:

    Great reads. You seem to be a little bullish on the dollar, as am I. I need to be, I depend on it’s purchasing power. :)

    Anyway, just wanted to thank you for all your posts. I am passing them around to my stressed friends.

  3. John Smith says:

    Good comment. It is a pitty that many people does not think like that. Thanks.

  4. Ron says:

    When do you think the Feds will implement the Amero currency? Do you think the Amero will be just as worthless as the current dollar? Do you think things will be far worse if they do bring in the Amero? What things can we expect to see (economy, society, housing, food, energy, foreign relations ect..) when they do bring in the Amero? If I were you I would start buying gold and silver coins which I am. Because those coins will be worth more than the dollar and the Amero.

  5. LaVern Isely says:

    Dear Sir,
    In reading your article, the best comment was “The balance of payments always balances.” When you are using DERIVATIVES which is something they are trying to define over in Basel, Switzerland on April 16 which was called Basel II where they are trying to get world-wide regulations on EXOTIC DERIVATIVES, I believe they are just trying to be nice because when you mix the income and expense together, there is no way to have a balanced budget. When you are trading a commodity for a DERIVATIVE that is virtually worthless, it’s not good business. This is what David Cay Johnston wrote in his book “Free Lunch.” If that wasn’t bad enough, you should read the latest GAO report (GAO-08-25) of October 2007. Senators Clinton and Obama are getting campaign money from the HEDGE FUND DEALERS but both of them say that the HEDGE FUND DEALERS SHOULD BE TAXED and until they do, the HEDGE FUND DEALERS which are sometimes headquartered down in the Caribbean, will be getting a free lunch at the expense of the middleclass taxpayers. the Parade magazine of April 13, 2008 entitled “Are You Paying For Corporate Fat Cats?” says “61% of U.S. corporations paid no taxes.” Unless the Democrats bring up the issue, I don’t think the Republicans will. I’m just wondering if the paid corporate lobbyists or the voters control our democracy.
    Yours truly, Disgusted Middleclass Taxpayer