Can the U.S. Win a Currency War?

June 20, 2019

President Trump wants a weaker dollar to depress imports, strengthen U.S. exports and import-competing domestic goods, and wean America off its reliance on globalized supply lines. He believes the dollar is fundamentally overvalued, and there is some merit to that claim. The most recent semi-annual update of the Economist’s BIG MAC index done last January revealed the greatest general dollar overvaluation in some 30 years. The U.S. currency then was very high-priced against both emerging market currencies and the monies of other advanced economies. The Swiss franc was one of very few currencies against which the dollar was undervalued, but the degree of franc overvaluation against the dollar had diminished to 19% from as much as 125% in the mid-1990s.

One problem with alleged measures of currency misalignment is that over/undervaluation is a relative concept, comparing current conditions to some arbitrary time in the past. It’s hard to believe that the dollar is currently more overvalued than early in the 1970s, when a devaluation in December 1971 followed by another in February 1973 gave way to a complete abandonment of fixed dollar parities backed by the U.S. guarantee of convertibility between gold and the dollar. Market forces overwhelmed the fixed dollar exchange rate framework. In 1968, a dollar could buy 3.99 marks (versus a synthetic 2.21 marks now), 360 yen (compared to 107.6 now), and 4.37 Swiss francs (versus 0.98 of a franc now).

Another problem with models that try to identify appropriate currency relationships is that such filter out many short-term determinants and fixate on relative inflation rates, which theoretically ought to be neutralized if a currency’s external purchasing power is to be held steady. As the economies of the world have become more interdependent, the influence of global factors on inflation has risen greatly, causing inflation rates to converge much more tightly and thus diminishing inflation’s role in differentiating the value of one currency from another.

It’s important also to realize that markets aren’t altruistic. The invisible hand identified by Adam Smith in the 18th century doesn’t command markets to adjust in the short run to suit the best interest of one economy or even all economies taken collectively. The task of currency markets is simply to find a price level that will clear the market by matching the quantity demanded at that price with the quantity supplied. A great many factors are at play in the background that will determine the market-clearing price, and there’s no reason to expect that it necessarily will meet a politician’s desire. All this begs the question of how to secure a less overvalued dollar assuming Trump’s allegation carries merit.

Remember, too, that Trump is identifying overvalued dollar relationships by looking for bilateral merchandise trade relationships in which the U.S. has large deficit. So naturally, the Chinese yuan, euro (as proxy for German mark), and Japanese yen get mentioned. A big drop in the dollar’s value against those currencies will not reduce the overall U.S. current account deficit, which is determined instead the discrepancy between U.S. domestic saving and domestic investment. It will only redistribute the geographic components of the deficit. The trade and current account gaps have widened under Trump in large part because of his economic policy changes such as the large corporate tax cut, a stimulative monetary policy, and plenty of deregulation.

A wide array of economic fundamentals are not aligned in a way that ought to yield a sustained downtrend in the dollar.  The growth slowdowns in Europe, Japan, China, Britain, and many emerging markets aren’t looking transitory. Trade wars are very toxic to growth. Trade ordinarily acts as a multiplying force. In economic upswings, trade flows generally expand faster than GDP, and vice versa. Tit-for-tat tariffs exert a broad drag on two-way trade flows and hence generate headwinds on GDP as well. U.S. growth slows too, but America retains relatively strong growth vis-a-vis the countries whose currencies Trump wants to see more highly valued. Their appreciation is also stymied by non-synchronized monetary policy cycles. With relatively higher growth that is slowing, the Fed is unlikely to cut interest rates and apply other tools of stimulus more aggressively than most other monetary authorities will be doing.

In a bygone era of closer economic cooperation among the governments of different nations, it was possible to redress perceived currency misalignments by conducting foreign exchange market interventions and making other macroeconomic policy changes that promoted currency rate adjustments that officials agreed to seek. The use of forex intervention, the direct buying of a currency to be strengthened against the sale of a currency officials want weaker, dropped generally out of favor long before Trump took office. When used, intervention seldom succeeded unless undertaken by several countries at once, and that kind of spirit no longer exists.

The dollar had great bouts of weakness not only in the 1970s but also during 1985-87, the mid-1990s, and 2002-04. The relative size of the U.S. current account deficit was much less manageable then than now. The first-quarter deficit, reported earlier today, equaled 2.5% of GDP, down from 2.8% in the last quarter of 2018 and way below the gap of 6.3% of GDP in the final quarter of 2005. Any thought now of replicating the Plaza Accord, which promoted dollar depreciation in the mid-1980s, is a total non-starter because the fundamentals don’t support it and America’s former allies lack the desire and ability to join such an effort. Maybe it would be different if China and the U.S. worked out a trade agreement, Britain avoids a no-deal Brexit, and the Fed surprises everyone with a rate cut greater than 25 basis points in one increment, but that’s pie in the sky thinking.

The longer run is different. The dollar chronically enjoys overvaluation status because it dominates all other reserve currency wannabe’s and the lucrative economic benefits of that role. The dollar acquired top reserve currency status initially because of a lot of intangibles like political stability, a credible rule of law, consistent foreign policies, deep financial markets, and the government’s acceptance of a collateral U.S. role as military and diplomatic leader of the free world. America gained special distinction by standing for a set of values, not a monolithic ethnic pool. All that seems to be eroding, and the strongest factor now ensuring that the dollar retains its top reserve currency status is simply the difficulty of changing horses so late into the race. If America continues to fight a cold civil war, a point will come eventually when world investors say enough is enough. It remains very uncertain when that might happen, and the so-called smart money is betting decades if not a generation or two. But like climate change, bad things often have a habit of evolving much more rapidly than experts anticipate initially.

Copyright 2019, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

 

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