Eichengreen is Wrong About the Dollar

Barry Eichengreen had an article yesterday in the WSJ (subscription required) about the waning appeal of the dollar. Most of the article details why the reign of the dollar as the world's preferred currency is coming to an end and he makes some very good points. At the end of the article however is this little piece of misinformation:

In this new monetary world, moreover, the U.S. government will not be able to finance its budget deficits so cheaply, since there will no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks.

Nor will the U.S. be able to run such large trade and current-account deficits, since financing them will become more expensive. Narrowing the current-account deficit will require exporting more, which will mean making U.S. goods more competitive on foreign markets. That in turn means that the dollar will have to fall on foreign-exchange markets-helping U.S. exporters and hurting those companies that export to the U.S.

My calculations suggest that the dollar will have to fall by roughly 20%. Because the prices of imported goods will rise in the U.S., living standards will be reduced by about 1.5% of GDP-$225 billion in today's dollars. That is the equivalent to a half-year of normal economic growth. While this is not an economic disaster, Americans will definitely feel it in the wallet.

The idea that we can make our trade deficit go away - and that we need to - simply by devaluing the dollar is something that sounds good in theory but has yet to work in the real world. In economics, the theory is called the J curve effect which says the trade deficit after a devaluation initially gets worse because the demand for imports is inelastic but eventually the deficit will improve as domestic consumers switch to cheaper domestic goods and foreigners switch to cheaper imports. It all sounds very logical but it hasn't worked out that way for the US in practice. We don't have to look hard to find evidence that devaluation doesn't work (at least so far for the US). The Bush administration pursued a weak dollar policy at the behest of manufacturing interests:

What happened to the trade deficit?

I suppose one could claim that the slight uptick at the end of the graph is the J curve effect but if it is, the rewards would seem to be rather slight and long in coming. More likely the slight "improvement" is due to the onset of US recession which is the only time over the last thirty years the trade deficit has been significantly reduced.

So why doesn't this so logical theory work in practice? It comes down to that latin phrase, ceteris paribus - all things being equal - that is a theoretical economist's best friend. Unfortunately, out here in the real world, all things do not stay equal. When we devalue the dollar our foreign competitors don't just throw up their hands and accept lower sales. Like businessmen everywhere, they compete. They invest in their business by making capital investments and become more efficient. Or they hedge away the risk of a falling dollar. It is also unlikely that domestic competition will emerge for many of the goods we import. I don't care how much the dollar falls - short of complete collapse - we won't be expanding our capacity to produce TVs or T shirts anytime soon. The wage differential is just simply too great. Even if we wanted to produce those goods domestically it would require capital investment which a weak dollar makes more scarce.

Another reason devaluation doesn't work, at least for the US, is that a large portion of our trade deficit is due to oil imports. We import nearly 12 million barrels of oil a day and like many commodities, oil is very sensitive to the movements of the dollar. Oil now represents over 50% of our trade deficit so unless we can somehow convince the oil producers of the world to accept cheaper dollars in exchange for oil, there is little hope of reducing the deficit through devaluation.

Devaluing the dollar, as Eichengreen rightly points out, reduces our living standards. I suppose there is some value for the dollar where we will be so poor that we will have to stop importing foreign goods but that seems a high price to pay for....what exactly? Why is it bad to run a trade deficit? For that matter, what exactly does a trade deficit mean?

There is nothing inherently bad about running a trade deficit. Every dollar that flows to foreign countries in trade must ultimately come back to the US to be spent on something. If we run a trade deficit the surplus dollars come back here as investment. If we run a surplus we get the opposite effect. That's it. The trade deficit just means Americans are getting cheap goods and benefiting from a high level of foreign direct investment. That doesn't sound like something that needs correcting.

As for Eichengreen's lament that interest rates will rise and make the deficit harder to finance, there is a relatively easy answer to that. Stop running budget deficits. That would most likely reduce the trade deficit too but it doesn't have to. If the budget deficit is reduced and private savings stays the same, investment will have to rise. The trade balance merely determines who makes those investments. If we run a trade deficit, foreigners will be making those investments and if we don't it will come from domestic savings. Either way, we get more investment in the US. The key, obviously, is to enact a set of policies that at least maintains private savings. Devaluing the dollar - reducing the real value of savings - would seem an odd policy choice to accomplish the task.

It is our policies that are driving most of the changes Professor Eichengreen notes. The fate of the US Dollar has yet to be decided.