The Dollar and the US Economy
Testimony before the Committee on Banking, Housing and Urban Affairs
United States Senate
The Rise of the Dollar
Since hitting its all-time lows in early 1995, the dollar has risen by a trade-weighted average of 40-50 percent in real terms against larger and smaller baskets of currencies of its trading partners. It has climbed by well over 50 percent against the yen and the European currencies. It could rise considerably further over the next year if the United States continues to recover more quickly and more robustly than Europe and Japan (or anybody else) from last year's worldwide slowdown, as is quite likely.
Every rise of one percent in the trade-weighted dollar produces a rise of at least $10 billion in the US current account deficit.1 Hence the currency's appreciation over the past seven years accounts for a large share of the total external imbalance, which will probably approximate $500 billion this year and be close to 5 percent of GDP, entering the traditional "danger zone" where the United States and other OECD countries have traditionally experienced correction of their external deficits.2 The deficits rose at an average rate of $100 billion (or over 50 percent) per year during the late 1990s, an explosive and obviously unsustainable path that may now have resumed. They dropped back to annual rates closer to $400 billion during 2001, with the drop in US economic growth and hence import levels, but rose again sharply in the first quarter of this year (and in fact subtracted 1.2 percentage points from our economic growth in that period).
Our latest projections at the Institute for International Economics suggest that, absent any corrective action, the US current account deficit will rise to 7 percent of GDP by 2006 (about $800 billion).3 The previous sharp falls in the dollar, which have occurred about once per decade since the early 1970s, were triggered by external imbalances that never even reached 4 percent of GDP. Our latest calculation is that the dollar is overvalued in trade terms by 20-25 percent, i.e., a depreciation of that magnitude would reduce the current account deficit to the level of around 2-2½ percent of GDP that is likely to prove sustainable over the longer run.4
These annual imbalances add to the negative net international investment position of the United States, which reached $2.2 trillion at the end of 2000 as a cumulative result of the deficits of the past twenty years. As recently as 1980, the United States was the world's largest creditor country. It has now been the world's largest debtor for some time. Its negative international investment position is rising by 20-25 percent per year. This trajectory too is clearly unsustainable.
The Impact of the Strong Dollar
These external deficits and debts levy several significant costs on the United States:
- Over the longer run, they mean that we will pay rising annual amounts of debt service to the rest of the world with a consequent decline in our national income. These payouts are surprisingly small so far, amounting to only about $14 billion in 2001, because foreign investment by Americans yields a substantially higher return than foreigners' investments here. However, the numbers are clearly negative and will become substantially larger over time.
- In the short run, any increases in the deficit subtract from our gross domestic product. Export output falls and domestic demand that could be met by domestic output is instead satisfied by higher imports. US output and employment suffer as a result and must be of concern unless the economy is at full employment because of booming domestic demand, as in the late 1990s (on which, see more below) but not now. Since most of our goods trade is in manufactured products, the deterioration of the trade balance has contributed substantially to the large, and perhaps permanent, loss of employment in that high-paying sector-whose wages average 13 percent higher and benefits average close to 40 percent higher than for the manufacturing sector as a whole.5
- At almost any time, markets could decide that the deficits and debt are unsustainable and reduce their new investments in dollars sufficiently to drive the exchange rate down sharply. The United States must attract about $2 billion of net capital inflow every working day to finance the deficits at their current level. Since gross US capital outflows have been running about as large as the current account deficit, our gross capital inflows must average about $4 billion per working day-and totaled about $1 trillion in 2000. Any decline in the level of these inflows, let alone their reversal via a selloff from the $10 trillion of outstanding dollar holdings of foreigners, would produce increases in the US price level and higher interest rates (and almost certainly a fall in the stock market as well). This "triple whammy" would severely hurt the US economy.6
- In terms of domestic policy, large external deficits and the overvalued dollar that produces them have been the most accurate leading indicator of resistance to trade liberalization throughout the postwar period. Paul Volcker has recently noted, for example, the correlation between the roughly 30 percent tariffs on steel just imposed by President Bush and the decline of roughly 30 percent in the value of the euro since its creation in 1999. The deficits generated relatively little concern in the late 1990s, because growth was so strong and unemployment so low, but are clearly doing so now as indicated by the other statements to the Committee this morning. Anti-trade pressures will almost certainly rise again if the economy fails to resume rapid growth on a sustained basis and especially if unemployment fails to fall much from its current levels.
- It should also be noted that a disorderly correction of the dollar's overvaluation would produce major foreign policy problems, especially with Europe. A decline of 20-25 percent in the average value of the dollar would require a much larger decline against the euro because the currencies of many of our closest trading partners (such as Canada and Mexico) would fall at least part of the way with the dollar itself. A complete dollar correction would in fact require the euro to rise well beyond its initial starting point in 1999 and more than 30 percent above current levels. This would sharply reduce Europe's competitive position and trigger major complaints there, deeply exacerbating the transatlantic trade conflict that is already so severe.7
At the same time, it must be recognized that the external deficits and dollar appreciation provided important benefits to the US economy during the boom period of the late 1990s. With growth at 5-6 percent in those years, and unemployment falling to a 30-year low of 4 percent, the sharp rise in net imports and the climb in the dollar itself helped to dampen inflationary pressures. The capital inflows that financed the deficit funded part of our investment boom and held interest rates in check, permitting monetary policy to accommodate the rapid growth. Under such circumstances, the "strong dollar" policy enunciated by the Clinton Administration (though never defined nor made operational) was defensible.8
No such defense is possible under current circumstances, however. The economic slowdown and rise in unemployment in 2000-01 underlined the costs of the external deficit. The absence of inflationary pressure obviates the chief benefit of large net imports. The sharp reduction in interest rates over the past year reduces the need for large capital inflows. Investment is now limited by excess capacity and lagging demand, rather than by any shortage of capital, so that particular benefit of the earlier inflows has largely disappeared.
It is thus stunning that Secretary O'Neill, in an interview published on March 15, suggested that the current account deficit is "a meaningless concept" and that "the only reason I pay attention to it at all is because there are so many people who mistakenly do"-a very different view that he expressed as CEO of International Paper in the middle 1980s when the dollar was also hugely overvalued and he could observe its impact directly. Similar statements of "benign neglect" by Secretary Donald Regan (and especially Under Secretary Beryl Sprinkel) in the first Reagan Administration turned out to be so wrong, and so costly for the economy, that they had to be totally reversed by the second Reagan Administration via the Plaza Agreement in 1985 to drive the dollar down by 50 percent over the succeeding two years.
A New Dollar Policy
It is thus time for a change in the dollar policy of the United States. There is no basis for maintaining the "strong dollar" mantra of the prior boom period. At a minimum, the United States and its G-7 partners should "lean against the wind" of any renewed dollar appreciation to keep the problem from getting worse. Indeed, they should now begin easing the dollar down toward its long-run equilibrium level through a combination of altered rhetoric and direct intervention to support other currencies, especially the euro.
The new policy should also make clear to other countries that the United States will not accept any efforts to competitively depreciate their currencies against the dollar. This dimension is particularly needed because Japan intervened massively last fall, once again, to keep the yen from rising as documented in the Treasury's latest Report to Congress on International Economic and Exchange Rate Policies. After halting the yen's rise, at about 116:1 against the dollar, the Japanese then actively talked it down to about 135:1. This latest episode of competitive depreciation of the yen apparently ended in January but it clearly had a major impact in the currency's level that persists today.
The Japanese characterized this intervention as part of an effort to combat deflation by pumping more yen into their economy. However, there are many other assets that the Bank of Japan could buy to expand domestic liquidity-even if one thought that doing so could be effective when demand for money is so low due to the depressed state of the Japanese economy. Moreover, it appears that the Bank of Japan sterilized the monetary effects of the currency intervention (as usual) so it made little or no contribution toward easing monetary conditions anyway.
The more plausible explanation of the intervention is that Japan was once again seeking to export its domestic economic problems to the rest of the world, as it has done on numerous occasions in the past. One can readily sympathize with Japan's plight, in light of its economy's "decade of decline" and the failure of so many of its efforts to use traditional monetary and fiscal instruments to restore growth.9 One might even countenance a temporary decline in the yen that resulted from implementation of needed reforms in Japan, as suggested by the Administration during its early days.
But the renewed rise of Japan's trade surplus that is already evident will ease pressure on the country to take the decisive steps needed to deal with the huge problems of its banking system-the fundamental requirement to get its economy back on trackand cannot be accepted as an alternative to such reforms. Moreover, especially in the context of last year's global economic slowdown, any such exporting of Japan's problems to other countries is highly inappropriate and must be resisted-through all the relevant multilateral forums, notably the IMF and G-7, as well as bilaterally by the United States.10It is thus disturbing that the new Treasury report ignores the problem even after identifying and acknowledging the existence of the massive intervention last fall, and indeed implies that is was somehow related to the terrorist attacks of September 11 and thus excusable.
On the broader issue of US currency policy, it is encouraging that neither Secretary O'Neill nor any other Administration official has repeated the "strong dollar" rhetoric since September 11, or even for some time before. Though the Treasury denies that there has been any change in policy, the absence of "strong dollar" language is promising. The Administration should now substitute advocacy of a "sound dollar," or some equivalent, to signal a substantive change in attitude.
The presumed reason for the Administration's reluctance to embrace such a shift is a fear that the dollar could then shift course abruptly and go into a sharp decline that would trigger some of the deleterious consequences cited above. There is little risk of any such "free fall" for the foreseeable future, however, in light of the far stronger fundamentals of the US economy (vis-à-vis both Europe and Japan) that have in fact held the dollar so high for so long. The dollar in fact remained quite strong during 2000-01 despite the sharp falls in US economic growth, interest rates and equity prices-all of which would have traditionally been expected to produce a depreciation of the exchange rate. At the same time, there are no foreseeable sharp pickups in Europe or Japan (or anywhere else) that would pull large amounts of investment away from the United States. Hence this is an excellent time to start easing the dollar down toward its sustainable equilibrium level, especially as it has already fallen by 3-4 percent over the past few months and that "leaning with the wind" is most likely to be effective.
The worst policy course is to wait until the inevitable change in economic fortunes, whenever it comes, triggers a shift in market sentiment against the dollar. Coming on top of the huge underlying imbalance, such an alteration of investor views could indeed trigger a very sharp fall in our currency and a "hard landing" for the economy. There is in fact a third factor that could then also kick in and make the ensuing adjustment even nastier: the likely structural portfolio shift into euros that will almost certainly occur at some point due to the likelihood that that currency, based on an economy as large as the United States and with even greater trade, will move up alongside the dollar as a global key currency.11
The risk of maintaining the Administration's policy of "benign neglect" would be substantially increased if the likely strong recovery of our economy over the next year or so were to trigger a renewed appreciation of the currency that, in combination with the growth pickup itself, would send our external deficits soaring even further.12 Under such circumstances, continuation of the "strong dollar" rhetoric would be particularly inappropriate because it would encourage an even greater rise in the currency's overvaluation. It would be a huge mistake to let the dollar rise to levels from which it would be even more certain to come crashing down.
Such a situation would be reminiscent of what actually occurred in 1984-85. Even after the "Reagan dollar" had risen by about 25 percent in 1981-83, and already shifted the US current account from balance in 1980 toward a deficit of over $100 billion, the dollar rose by another 25 percent or so in what all subsequent analysts have characterized as a purely "speculative bubble." The Reagan Administration itself was then forced to engineer the Plaza Agreement in September 1985 to drive the dollar down by more than 50 percent against the other main currencies by the end of 1987.
There are of course those who doubt the effectiveness of sterilized intervention in the currency markets. Such a view ignores the fact that all three cases of intervention by the Rubin-Summers Treasury worked in textbook fashion. Joint US-Japan intervention stopped and reversed the excessive strengthening of the yen in 1995. Similar intervention stopped and sharply reversed the excessive weakening of the yen in 1998. Joint US-EU intervention in late 2000 stopped the slide of the euro and prompted a 10 percent rebound. But the best evidence comes from the administration itself: why is it so afraid to alter the "strong dollar" mantra if it believes there would be no impact from doing so? Does anyone really think that the dollar would fail to decline toward a more desirable level if Secretary O'Neill and his G-7 colleagues were to start calling for such a correction? An effective alternative policy is clearly available.
We also know that currency depreciation, supported by sound domestic policies, produces the desired changes in current account balances with a lag of two or three years. The large dollar decline of 1985-87, for example, led to virtual elimination of the US current account deficit in the early 1990s. The sharp appreciation of the yen produced a similar correction in the Japanese surplus.
Hence there is a strong case for a new US policy toward the dollar. Virtually every sector of the economy is now calling for such a change, as indicated at this hearing: the business community through the National Association of Manufacturers, labor through the AFL-CIO, agriculture through the American Farm Bureau. Important parts of Wall Street, including former Fed Chairman Paul Volcker and the chief economist of Goldman Sachs, have issued similar calls. It is time for the Administration to change its policy toward the dollar, to improve the prospects for the US economy and US trade policy, and to reduce the risks of the much more severe adjustment that will inevitably hammer us later if it continues to ignore the problem.
2. See Catherine L. Mann, Is the US Trade Deficit Sustainable?, Washington: Institute for International Economics, September 1999, especially pp. 156-57, and Caroline Freund "Current Account Adjustment in Industrial Countries" International Finance Discussion Papers 692: Federal Reserve Board of Governors, December 2001.
4. Simon Wren-Lewis, Exchange Rates for the Dollar, Yen and Euro, International Economics Policy Brief 98-3, Institute for International Economics, Washington, July 1998. The International Monetary Fund has publicly expressed a similar view, e.g., in its World Economic Outlook of May 2001.
5. Howard Lewis III and J. David Richardson, Why Global Commitment Really Matters! Institute for International Economics, October 2001.
7. C. Fred Bergsten, "The Transatlantic Century," The Washington Post, April 2002.
9. Adam Posen, Restoring Japan's Economic Growth, Washington: Institute for International Economics, 1998.
10. C. Fred Bergsten, Marcus Noland and Takatoshi Ito, No More Bashing: Building a New Japan-United States Economic Relationship, Washington: Institute for International Economics, 2001.
12. The sharp reduction in the US budget surplus, resulting from the tax cuts of early 2001 and the post-September 11 stimulus package, further enhances the prospect of larger trade deficits via a strong dollar. The fall in the surplus means that government saving will decline sharply, by perhaps 2-3 percent of GDP, and that an equivalent amount of additional foreign capital will have to be imported-implying a similar jump in the trade deficit-unless private saving were to rise by a like amount, which is not only unlikely but undesirable since the goal of the stimulus efforts is to promote increased consumer demand and thus a restoration of rapid economic growth. See C. Fred Bergsten, "Can the United States Afford the Tax Cuts of 2001?" American Economic Association, January 5, 2002.