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Monday, November 05, 2007

Dean Baker: Down with the Dollar

Now that the dollar is starting to fall, it's time to play the blame game. Is it fixed exchange rate policies by foreign countries, the administration's tax-cuts and subsequent deficits, or what? Dean Baker says the dollar's problems can be traced to the strong dollar policy pursued by Robert Rubin during his time as Secretary of the Treasury under Clinton:

Down with the dollar, by Dean Baker, Comment is Free: In recent weeks, the dollar has been plummeting in value relative to the euro, the pound, and other major currencies. This continues a decline that began six years ago. Since 2001, the dollar has lost 30% of its value against the British pound, 39% of its value against the euro, and 41% of its value against the Canadian dollar...

The decline in the dollar is leading to a bit of a panic in some circles. For example, the New York Times has published at least two editorials recently decrying the falling dollar and blaming President Bush's tax cuts. Last week, Robert Rubin, who was Treasury secretary in the Clinton administration and a major proponent of a strong dollar, warned that the falling dollar would lead to higher inflation and a lower standard of living. Many others have expressed similar concerns.

These rants might be humorous if there was not a danger that they could affect policy. Therefore we must stop laughing at the United States' leading newspaper and our former Treasury secretary and carefully explain why the dollar is falling.

The top reason on this list is the US trade deficit. In 2006 the United States imported $2,230bn worth of goods and services from abroad. It only exported $1,470bn. The $760bn gap corresponds to an excess supply of dollars on international currency markets. This large excess supply of dollars puts downward pressure on the dollar...

Of course trade is not the only source of demand for dollars. Investors will want dollars insofar as they want to invest in the US. ... In addition, foreign central banks, most importantly the Chinese central bank, have been buying up hundreds of billions of dollars of US bonds in a conscious effort to prop up the dollar. This keeps their exports cheap for people in the US, thereby sustaining their export market.

In the late 1990s, the flow into dollars for investment purposes exceeded the outward flow due to the trade deficit, thereby causing the dollar to rise. This rise in the value of the dollar had the positive short-term effects noted by Rubin: it lowered inflation and raised living standards by making foreign goods cheaper for people in the US.

However, the high dollar inevitably meant that the trade deficit would expand through time as trade patterns gradually adjusted... This meant that sustaining the value of the dollar would require ever larger investment flows. While these investment flows did reach enormous levels, it was inevitable that the size of the annual capital inflows would eventually hit a limit.

This limit has now been reached. And with the dollar now falling, investors are increasingly wary about putting their money in dollar-denominated investments. If not for the decision of the Chinese central bank to intensify its efforts to prop up the dollar..., the dollar would be falling even more rapidly.

So who is to blame for the falling dollar in this story? The answer is simple: Robert Rubin and the people who let it become overvalued in the first place. The high dollar of the second Clinton administration produced beneficial short-term effects (at least for people who did not have to compete against imports), but had inevitable long-term costs. We are now experiencing these long-term costs in the form of the decline of the dollar, which will lead to higher inflation and quite likely higher interest rates.

In this particular case, President Bush and his tax cuts are innocent bystanders. ... In short when looking for people to blame for the falling dollar, the spotlight should be focused on the people who gave us the high dollar. It was a story of short-term gain for long-term pain, just like the Bush tax cuts, except the impact of the overvalued dollar is considerably larger.

    Posted by on Monday, November 5, 2007 at 11:43 AM in Economics, International Finance | Permalink  TrackBack (0)  Comments (36)

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