With The Illusion of Saving as background let me explore a very counterintuitive proposition: That the growth in the budget deficit might indirectly strengthen the dollar.
It might do so by requiring a larger capital inflow (and thus a larger current account deficit) to make up for the shrinkage in domestic saving relative to investment caused by the growing budget deficit.
When domestic saving is inadequate to finance planned investment, investment must shrink to the savings available, or the saving must be imported from abroad via a larger capital inflow financing a larger current account deficit. The imbalances will affect and be affected by many economic variables, but the impact of the exchange rate on the current account balance is surely a principal one. Since a growing budget deficit seems inexorable, the needed saving will put upward pressure on domestic interest rates and upward pressure on the exchange rate.
Other things equal, a stronger dollar will weaken our current account balance by making imports cheaper and our exports more expensive. Bottom line: the budget deficit may strengthen the dollar. It doesn't seem right, does it?
If you are not convinced, lets start over and approach it as follows.
Without having to resort to numbers, I think we can all agree on the following:
*Consumers are stressed and will be hard pressed to increase personal saving substantially.
*The budget deficit is in the process of an historic explosion-increasing the negative saving coming from the government sector.
*National saving from those two sources is in a sharp decline.
*Other than pulling down investment drastically to match the shrunken saving, we need to borrow more saving from abroad to supplement domestic saving.
*We get more foreign saving by running larger current account deficits, which are financed by larger capital inflows. Those larger capital inflows are what we need.
*Greater capital inflows respond to many economic variables, but mainly they finance the current account deficit.
*To attract more foreign capital, we need to run a larger current account deficit.
*The main way to get an increase in the current account deficit is for the dollar to appreciate and become less competitive, i.e., stronger and for domestic interest rates to rise.
*The need for more saving, made much more acute by the budget deficit, will put upward pressure on the dollar.
*Therefore, the budget deficit will strengthen the dollar.