The Dollar, the Deficits, China Holdings and Domestic Investment

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.

Comments (6)

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  1. John Booke says:

    Bob I agree we should not raise the tax rate to strengthen the dollar. A much better way would be to raise the maximum income on Social Security taxes from $106,500.00 to $1,000,000.00. This would not only provide more tax revenue and boost the value of USD but also help balance income inequality in the US.

  2. Brian W. says:

    Thanks, Bob . This is a great explanation. You have a real knack for explaining complicated topics and showing how they are interconnected.

  3. I’m kind of an old fashioned “stable” dollar guy myself. In running a business, one of the most important things is the ability to lessen the number of uncertainties. It’s difficult to invest when worrying about potential tax increases or higher borrowing costs. It may be a pipe dream, but I’d like to see some rational government policy which takes seriously the long and short-term effects of deficit spending.

    I know most liberals don’t take the Laffer Curve seriously, but I think there’s some decent evidence to support it. In other words, raising tax rates isn’t necessarily going to achieve much greater revenue. So, go with what works. Cut spending and allow the private sector to function in a way that will eventually improve our economic standing and, by extension, strengthen the dollar.

  4. [...] many are concerned about growing deficit spending and the devaluing of the dollar.  Yesterday Bob McTeer wrote a very good piece on how the dollar, deficits, and China’s holding of U.S. debt are all [...]

  5. Mark says:

    All things being equal, wouldn’t an increase in savings (over investment), leading to an increase in net exports also lead to a declining dollar? …Excess dollars available for foreign exchange…

  6. Bob McTeer says:

    Mark:

    This makes my head hurt.

    I = S
    G=T
    X=M

    If S rises relative to I, and if G = T is unchanged, then M must fall relative to
    X. An decrease in demand for M or increase in demand for X would
    strengthen the dollar, I believe. I suppose, theoretically, that some other
    combinations of economic changes could produce the necessary
    adjustment in net exports, but I think the dollar is likely to be involved.