We continue to discuss the topics above as separate issues, without acknowledging their interdependence. They are mutually determined as in the solving of simultaneous equations. For example, our budget deficit indirectly, and our current account deficit more directly, affect the dollar exchange rate and the size of our trade deficit (and capital inflow). With China’s trade surplus being the main counterpart to our deficit, its inflow of dollars to China depends more on the size of that imbalance than their desire for dollars over other currencies.
Our national saving—made up of personal, business and government saving—is being supplemented by the foreign capital inflow that finances our current account deficit and helps support domestic investment. The floating dollar adjusts to help maintain the necessary relationships.
China has absorbed fewer dollars lately because our trade deficit has shrunk as reduced domestic demand has reduced our demand for imports more than reduced foreign demand has reduced the demand for our exports. China’s dollar holdings are influenced by everything that affects our trade deficit and capital inflow, including our budget deficit, along with personal and business saving. Those holdings aren’t independent of these complex relationships.
If any category of our national saving increased, other things equal, our current account deficit would tend to shrink. An appreciating dollar would likely be part of that adjustment process. So, more personal saving, more business saving, or more government saving (a smaller deficit) would all tend to strengthen the dollar. Conversely, a reduction in those categories by our trading partners would have a similar effect.
One caution: if the government increases its deficit to increase transfer payments, which get saved by the recipients, there is no increase in national saving. The greater government dissaving offsets the greater personal saving.
Everyone would be happier campers if we saved more domestically and China and other trading partners would consume more and save less domestically. This would indirectly reduce the trade imbalances and the comparable capital flows and ease the downward pressure on the dollar.
Of course, government saving is tax revenue minus government expenditure; so more government saving could occur either through less spending or more tax revenue. Note that I said tax revenue, not tax rates.
Under those circumstances the dollar would be strengthened by the fundamentals. Attempts to support the dollar without the underlying support of the fundamentals would be like moving the dial on a thermometer without changing the temperature.