The Dollar's Depths, Explained
But there are some good things about a weak dollar, too.
There are. It's good for U.S. workers, because it shifts demand to cheaper U.S. goods. For all the stress Ford and General Motors are under, it would be worse if the dollar were stronger. Basically, any U.S. company that competes with foreigners benefits from a weaker dollar. But there are bad things, too. Foreign goods are more expensive than they would otherwise be, which includes everything from French wine to travel to appliances.
Doesn't the global economy mean there are plenty of alternatives to these kinds of goods?
Yes, but whenever you're substituting away from your preferred choice, there's a loss of utility. Foreign travel is a good example. In many places, it's at least 20 percent more expensive for Americans to travel now than a few years ago.
I see your point. There's no substitute for Paris.
Unless you count Miami Beach.
OK, I'm convinced. A strong dollar is a good thing. So what drives the dollar up or down?
There are two primary forces, the current account deficit—which is primarily the trade deficit—and the capital flows that finance the trade deficit. And there's always tension between which is the dominant force.
Why the trade deficit?
If we're buying more goods overseas than we're selling to foreigners, we're demanding foreign currencies more than foreigners are demanding dollars. That drives up the price of foreign currencies if you're buying them in dollars.
And that's the same thing as the dollar falling in value.
What about the capital flows?
Well, when foreigners invest in U.S. assets, they have to buy dollars, and when we invest in foreign assets, we have to buy foreign currencies first. The trade deficit means that foreigners are acquiring more U.S. assets than we are acquiring foreign assets.
And that's what has been happening?
Yes, the U.S. current account deficit is about $800 billion a year, which means every business day we buy in excess of $3 billion of foreign goods and services more than foreigners buy here.
Which also means that every day, foreigners invest $3 billion in the U.S. economy.
Right. And our asset prices, interest rates, exchange rates, and stock prices adjust continuously to make this happen.
There's a kind of a self-correction mechanism built into that, isn't there? As the dollar's value falls, U.S. goods and services get cheaper, which leads foreign consumers to buy more of them. That would help stabilize the dollar, right?
Yes, and that's one of the forces people think is keeping the dollar from weakening further. Also, you can't run a large current account deficit forever.
Because eventually foreigners will own your entire economy. Before that happens, you stop buying as many foreign goods, because they start to get expensive, and you start selling them more of your goods.
Can you point to any examples in the economy where that's happening?
Yeah. Caterpillar tractors. With construction booming around the world, demand is high for earth-moving equipment. You can either buy it from Japan or the United States, and a lot of people are buying Caterpillar equipment that's made in the United States.
Hold on a second—why don' you help me find all these numbers we've been talking about.
OK. Start at the Bureau of Economic Analysis, then under "International" select "Balance of Payments," then select the news release on "International Transactions." Under "Goods and Services," you'll see that the latest quarterly deficit was about $177 billion. Then, if you scroll down, under "Financial Account," you'll see that net financial inflows were about $203 billion. There are a few things not accounted for in the numbers, but in rough terms, the $203 billion balances the current account deficit.
OK, got it. But explain how that affects the value of the dollar.
The value of the dollar goes up or down as needed to keep those accounts in equilibrium. Investors increase or decrease their investments in the United States based on their expected rates of return here, and the exchange rates fluctuate as people buy and trade. Again, there are two major forces, the trade force and the investment force.
This is where currency traders come in, right?
Right. Currency traders intermediate hundreds of billions of dollars in cash flows. When I buy Chinese goods, for instance, the guy who sells them wants to be paid in Chinese yuan. A German investor who sells me a German asset wants to be paid in euros. Currency traders make that happen.
How big a role do speculators play in currency exchange?
A big role. Currency traders and speculators are the same people. If you're a currency trader and you think one currency is likely to weaken, you'll sell that currency as quickly as possible. That lowers the price, or the value of that currency. Currency traders are often on the opposite side of "fundamental" trades, which are purchases of goods, or mutual fund investments, or international investments done for strategic corporate reasons, let's say—like if General Motors buys a factory in China. There's probably at least 10 times as much currency trading that's speculative, rather than fundamental.
So when consumers hear of "speculators," that sounds like something that could be destabilizing. Is it?
I don't think currency speculators are a force for instability. They create liquidity. They create the whole market for currencies, really.
So where do threats of instability come from?
There are several major factors. Inflation is a big one. Right now, inflation is generally quite low, and comparable among the major countries, except for Japan, which is a little lower than the United States and Europe.
That's good, right?
Well, it drives down the nominal rate of return that investors will get, but it also aids stability.
And of course investors like predictability.
Right. Another factor is the growth rate of the economy, and as you know there are concerns that the U.S. economy could slip into recession, induced by declines in the housing market. Growth in Europe and Japan, and more so in China and India, leads to generally higher rates of return for people who invest in those countries.
What are some other factors that can cause instability in exchange rates?
Threats of war are an obvious one. If there were another major terrorist attack in London, it would probably lead to a stronger dollar. Oil is another one. Oil is priced in dollars. Then the question is: How do the producers of oil invest the dollars they are saving? If they're investing in dollars, then that's good for the dollar. If not, it could weaken the dollar.
That involves organizations like the Kuwaiti Investment Authority and other huge investors from the Middle East. Do we know how they invest all their money?
It's very hard to know that.
What are some of the ways for the dollar to get stronger?
Well, the trade deficit is weighing on the dollar, and if the United States can grow its way out of the problem, that would be great. The current account deficit might stay relatively constant, but if the economy grows, then that deficit will represent a lower portion of gross domestic product.
Aren't there some risks that come with a weaker dollar, too?
Sure. Foreigners could decide that they're tired of financing our current account deficit by investing in the United States, in which case they'd demand a lower price for our bonds and a higher yield to invest in dollars. That would weaken the dollar. Or the Asian central banks could decide they were holding too many U.S. government securities or other dollar-backed assets, and decide to diversify.
But China's central bank, or any foreign investor, doesn't think like that, right?
Right, because they'd be shooting themselves in the foot.
They'd be dissing their biggest customer—America.
Right. They have other goals that are much more important. Their goals are employment gains and continued growth in their economy. They need us to fulfill those goals.
Are you willing to make a guess about which direction the dollar will go over the next year?
I'd prepare for the full range of possibilities. Investor psychology is all over the map.
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