The Dollar’s Doldrums
Economic commentators are better at rationalizing past exchange-rate movements than at forecasting future trends. So, when it comes to explanations for the dollar’s decline over the past year, we are confronted by an embarrassment of riches.
BERKELEY – Donald Trump’s first year as US president has been, if nothing else, a bounteous source of surprises.
One of the big ones in the circles I frequent is dollar weakness. Between January 2017 and January 2018, the broad effective exchange rate of the dollar fell by 8%, wrong-footing many of the pundits. I include myself among the wrong-footed (others can decide whether I qualify as a pundit).
Tax cuts and interest-rate normalization, I expected, would shift the mix toward looser fiscal and tighter monetary policies, the combination that drove up the dollar in the Reagan-Volcker years. Tax changes encouraging US corporations to repatriate their profits would unleash a wave of capital inflows, pushing up the dollar still further. New tariffs that made imports more costly and that shifted demand toward domestic goods would require offsetting effects in a near-full-employment economy in order to shift demand back to foreign sources. The most plausible such offset was, of course, appreciation of the real exchange rate, which could occur only through inflation or, more plausibly, a stronger dollar.
The markets, in their wisdom, rejected this logic for more than a year. It is thus incumbent upon those who of us made such predictions to “mark our views to market,” as my Berkeley colleague Brad DeLong likes to say.
Economic commentators are better at rationalizing past exchange-rate movements than at forecasting future trends. So, when it comes to explanations for the dollar’s decline over the past year, we are confronted by an embarrassment of riches.
The most popular explanation for dollar weakness is that Trump, through incompetence or misdirection, failed to deliver what he promised. There was no across-the-board import tariff. There was no abrogation of the North American Free Trade Agreement. There was no $1 trillion infrastructure package.
But there were, in fact, deep tax cuts. There were, in fact, interest-rate hikes by the Federal Reserve. And there were, in fact, tax changes creating incentives for the repatriation of profits. Other things equal, these developments should have propped up the dollar. So there must be more to its weakening than just Trump’s failure to deliver.
Another popular explanation is that investors expected the real exchange rate to rise through inflation rather than currency appreciation. The dollar weakened, in this view, because the Fed fell behind the curve and risked losing control of the inflation process.
Conceivably, this interpretation could prove correct. But it is not correct yet. There was no surge in inflation between January 2017 and January 2018. Currently, the fear in the markets is not that the Fed is behind the inflation curve but that it will raise interest rates even faster than expected in order to preempt overheating. And if higher interest rates are good for one thing, they’re good for the dollar.
Beyond this, there are at least 17 other narratives to explain dollar weakness. Some are insightful. Others are entertaining. Most, however, overlook the most plausible explanation, which is Trump-related uncertainty.
Investors have no way to forecast the impact of policies, because policies thought to be headed one way suddenly veer in the opposite direction. A big infrastructure bill turns out to be small. Withdrawal from the Trans-Pacific Partnership trade agreement turns into a possible decision to re-enter TPP. Steve Mnuchin, the Treasury secretary, seemingly abandons the United States’ strong-dollar policy but then re-embraces it. Uncertainty is the order of the day, every day.
And there’s nothing investors like less than uncertainty. This is especially true of investors in a currency whose strongest attraction is its safe-haven status. Investors traditionally flock to the dollar not simply because it is stable, but also because it tends to strengthen in a crisis, given that its issuer has impregnable defenses and possesses the deepest and most liquid financial markets in the world.
But now that issuer also has a president who is casting doubt on his country’s defense alliances and who is, consciously or not, encouraging his Russian counterpart, Vladimir Putin, to build, or at least boast of, new offensive weaponry. It has a president who has encouraged the idea of a government shutdown, fueling doubts about the liquidity of the market in US Treasury bonds.
More chaos in the White House would only depress the dollar further. Working in the other direction is the fact that some of the dollar-supportive measures that observers expected Trump to adopt, such as tariffs on steel imports, are now coming, like it or not. It may be indicative that on March 1, when Trump announced his steel and aluminum tariffs and the stock market tanked, the dollar strengthened. Uncertainty may continue to dominate, but it may also be that the dollar’s rise on March 1 was a harbinger of what is to come on foreign-exchange markets.
How to Lose a Trade War
The Trump administration's imposition of so-called safeguard tariffs on imports of solar panels and washing machines is directed mainly at China and South Korea. But, while neither country is responsible for America's large trade deficit, further protectionist measures seem certain – and will leave US consumers worse off.
NEW HAVEN – Protectionist from the start, US President Donald Trump’s administration has now moved from rhetoric to action in its avowed campaign to defend US workers from what Trump calls the “carnage” of “terrible trade deals.” Unfortunately, this approach is backward-looking at best. At worst, it could very well spark retaliatory measures that will only exacerbate the plight of beleaguered middle-class American consumers. This is exactly how trade wars begin.
China is clearly the target. The January 23 imposition of so-called safeguard tariffs on imports of solar panels and washing machines under Section 201 of the US Trade Act of 1974 is directed mainly at China and South Korea. Significantly, the move could be the opening salvo in a series of measures.
Last August, the US Trade Representative launched Section 301 investigations against China in three broad areas: intellectual property rights, innovation, and technology development. This is likely to lead to follow-up sanctions. Moreover, a so-called Section 232 investigation into the national security threat posed by unfair steel imports also takes dead aim at China as the world’s largest steel producer.
These actions hardly come as a surprise for a president who promised in his inaugural address a year ago to “…protect [America’s] borders from the ravages of other countries making our products, stealing our companies, and destroying our jobs.” But that’s precisely the problem. Notwithstanding the Trump administration’s cri de coeur of America First, the US could well find itself on the losing side of a trade war.
For starters, tariffs on solar panels and washing machines are hopelessly out of step with transformative shifts in the global supply chains of both industries. Solar panel production has long been moving from China to places like Malaysia, South Korea, and Vietnam, which now collectively account for about two-thirds of America’s total solar imports. And Samsung, a leading foreign supplier of washing machines, has recently opened a new appliance factory in South Carolina.
Moreover, the Trump administration’s narrow fixation on an outsize bilateral trade imbalance with China continues to miss the far broader macroeconomic forces that have spawned a US multilateral trade deficit with 101 countries. Lacking in domestic saving and wanting to consume and grow, America must import surplus saving from abroad and run massive current-account and trade deficits to attract the foreign capital.
Consequently, going after China, or any other country, without addressing the root cause of low saving is like squeezing one end of a water balloon: the water simply sloshes to the other end. With US budget deficits likely to widen by at least $1 trillion over the next ten years, owing to the recent tax cuts, pressures on domestic saving will only intensify. In this context, protectionist policies pose a serious threat to America’s already-daunting external funding requirements – putting pressure on US interest rates, the dollar’s exchange rate, or both.
In addition, America’s trading partners can be expected to respond in kind, putting export-led US economic growth at serious risk. For example, retaliatory tariffs by China – the third-largest and fastest-growing US export market – could put a real crimp in America’s leading exports to the country: soybeans, aircraft, a broad array of machinery, and motor vehicles parts. And, of course, China could always curtail its purchases of US Treasuries, with serious consequences for financial asset prices.
Finally, one must consider the price adjustments that are likely to arise from the inertia of existing trade flows. Competitive pressures from low-cost foreign production have driven down the average cost of solar installation in the US by 70% since 2010. The new tariffs will boost the price of foreign-made solar panels – the functional equivalent of a tax hike on energy consumers and a setback for efforts to boost reliance on non-carbon fuels. A similar response can be expected from producers of imported washing machines; LG Electronics, a leading foreign supplier, has just announced a price increase of $50 per unit in response to the imposition of US tariffs. American consumers are already on the losing end in the Trump administration’s first skirmishes.
Contrary to Trump’s tough talk, there is no winning strategy in a trade war. That doesn’t mean US policymakers should shy away from addressing unfair trading practices. The dispute-resolution mechanism of the World Trade Organization was designed with precisely that aim in mind, and it has worked quite effectively to America’s advantage over the years. Since the WTO’s inception in 1995, the US has filed 123 of the 537 disputes that have been brought before the body – including 21 lodged against China. While WTO adjudication takes time and effort, more often than not the rulings have favored the US.
As a nation of laws, the US can hardly afford to operate outside the scope of a rules-based global trading system. If anything, that underscores the tragedy of the Trump administration’s withdrawal from the Trans-Pacific Partnership, which would have provided a new and powerful framework to address concerns over Chinese trading practices.
At the same time, the US has every right to insist on fair access for its multinational corporations to operate in foreign markets; over the years, more than 3,000 bilateral investment treaties have been signed around the world to guarantee such equitable treatment. The lack of such a treaty between the US and China is a glaring exception, with the unfortunate effect of limiting of US companies’ opportunities to participate in the rapid expansion of China’s domestic consumer market. With trade tensions now mounting, hopes of a breakthrough on a US-China investment treaty have been all but dashed.
Trade wars are for losers. Perhaps that is the ultimate irony for a president who promised America it would start “winning” again. Senator Reed Smoot and Representative Willis Hawley made the same empty promise in 1930, leading to protectionist tariffs that exacerbated the Great Depression and destabilized the international order. Sadly, one of the most painful lessons of modern history has been all but forgotten.
Trumping the Dollar
It is still too early to know for sure why the value of the dollar has declined in recent months. But if the Trump administration does indeed pursue a deliberate policy of isolationism, foreign-exchange markets' increasing risk premia on the dollar will have been justified.
LONDON – One of the more fascinating developments in the seven months since US President Donald Trump was elected has been the trajectory of the US dollar, relative to other major currencies. After soaring in the wake of Trump’s victory, the dollar’s value began to slide in April.
There are various explanations for this. One is that Trump’s much-anticipated economic-growth agenda has not materialized, and stands no chance of making it through Congress. Another is that the rest of the world, not least the eurozone, has performed better than expected since Trump’s election.
I spent decades immersed in the intricacies of the foreign-exchange market, so I know that it is foolhardy to assume that one can ever know everything that is going on. Still, beyond the cyclical explanations for today’s trends, a third explanation has become increasingly clear: markets have built in a risk premium for the dollar, to account for the uncertainties that Trump’s presidency has introduced.
In the course of estimating the underlying equilibrium value of the dollar and other currencies, I have developed a process for approximating where a currency “should” be trading, all things being equal. This process has generally served me well, insofar as anything can serve one in the world of foreign exchange. And assuming that it is at least vaguely accurate, we can conclude that any resulting deviation in the actual value of a currency represents some kind or premium or discount.
According to conventional economic theory, the exchange rate can be calculated in terms of a currency’s so-called purchasing power parity (PPP): if the same basket of goods can be purchased with the same number of euros as dollars, then the exchange rate is 1:1. But in the early 1990s, I came to regard this approach as insufficient, because it failed to take into account that the underlying real (inflation-adjusted) exchange rate could itself vary.
Béla Balassa, Paul Samuelson, and John Williamson were among the earliest economists to estimate the real exchange-rate equilibrium that, in a perfect world, also reflects the balance-of-payments and full-employment equilibria. But when I was at Goldman Sachs, I developed my own very simple version of this framework: the Dynamic Equilibrium (Real) Exchange Rate (GSDEER). Right now, the GSDEER for the euro-dollar exchange rate is around €1:$1.20, which would suggest that the dollar is overvalued against the euro by about 6-7%.
I also developed what I called the Adjusted GSDEER, which corrects the “equilibrium” rate for the ongoing economic cycle, by accounting for factors such as the real interest-rate differential between the US and the eurozone. Which interest rate is best for making comparisons is a matter of debate, as are the effects of quantitative easing; but I see no good reason not to use the ten-year government bond differential, adjusted for inflation expectations.
Accordingly, the Adjusted GSDEER for the euro-dollar exchange rate, as of June 7, was €1:$1.0590. Given that the dollar was trading at around $1.1250 against the euro on that day, this suggests that the dollar is actually around 6% weaker than it should be.
Now, of course, 6% is not a particularly significant difference, and this finding may not mean anything at all. Those who are bullish on the dollar (and who probably have plenty of underlying biases) would tell you that now is an ideal time to buy dollars, as the value is sure to rise. They may be right. The US economy could start to grow at a faster rate; Trump might somehow get some of his growth-boosting policies enacted; and Europe’s growth may taper off.
On the other hand, the eurozone could maintain its amazing ascent; and the Trump administration may continue to disappoint. Moreover, Trump’s proposed policy framework might very well deserve to have a rising risk premium. It is still too early to know for sure, given that the stock market continues to reach new heights, while US bond yields have softened. But if the Trump administration does indeed pursue a deliberate policy of isolationism, high risk premia on the dollar will have been justified, especially when one accounts for the persistently low US domestic savings rate and high dependency on net foreign capital.
Some economic observers have long believed that the US cannot sustain an economy in which personal consumption constitutes 70% of GDP. And for a brief period in 2008-2009, it looked as though the US economy could be on the verge of a major structural adjustment, some of which could have been helpful, if it reduced consumer dominance. Fortunately, the worst was avoided. But almost a decade later, US domestic consumption once again accounts for more than 70% of GDP.
There are good ways and bad ways to shrink the consumption share of GDP to a more appropriate size. The good way is for the US to import less and export more, and to increase its domestic savings and investment. The bad way – particularly for American consumers – is for the US to pick fights and retreat from the world. Trump and his advisers would do well to act accordingly.
Is Trump Killing the Dollar?
For nearly a century, the US dollar has been viewed as the financial world’s ultimate safe haven. But after 200 days of chaos under US President Donald Trump, the value of the dollar has declined, and global investors and central banks have begun to look for alternatives in other markets.
SANTA BARBARA – For nearly a century, the US dollar has been viewed as the financial world’s ultimate safe haven. No other currency has promised the same degree of security and liquidity for accumulated wealth. In past times of trouble, skittish investors and prudent central banks have all piled into dollar-denominated assets, not least US Treasury bonds. This may no longer be the case.
US President Donald Trump’s chaotic administration has severely undermined confidence in the greenback. Since being inaugurated before a phantom crowd of millions, Trump has picked fights with one government after another, including allies like Australia and Germany. More recently, he has taken the world to the brink of nuclear war by locking horns with North Korean dictator Kim Jong-un.
The dollar is about to face a serious test. Will global investors continue to put their money in a country whose leader loudly provokes the Hermit Kingdom with threats of “fire and fury,” or will they find financial refuge elsewhere?
Not since World War II has the safety of the dollar been in such doubt. In the post-war period, America’s extraordinarily large and well-developed financial markets promised unparalleled liquidity. And because the US was the dominant military power, it could ensure geopolitical security, too. No country was in a better position to supply safe and flexible investment-grade assets on the scale the global financial system required. As New York investment strategist Kathy A. Jones told the New York Times in May 2012, “When people are worried, all roads lead to Treasuries.”
The bursting of the US real-estate bubble in 2007 is a case in point. Everyone knew that the financial crisis and ensuing recession had started in the US, and that the country was to blame for a near-collapse of the global economy. And yet, even at the height of the crisis, a tidal wave of capital flowed into US markets, enabling the US Federal Reserve and Department of the Treasury to implement their response.
In the last three months of 2008 alone, net US-asset purchases topped $500 billion dollars – three times more than what was purchased in the preceding nine months. Far from depreciating, the dollar strengthened. The Treasury-bond market stood out as one of the few financial sectors that was still operating smoothly. Even after the credit-rating agency Standard & Poor’s downgraded Treasury securities in response to a brief US government shutdown in mid-2011, outside investors continued to acquire dollars.
Much of the spike in demand for dollars ten years ago could be attributed to sheer fear: no one knew how bad things might get. The same could be said of the US and North Korea’s escalating confrontation today. But will history repeat itself, and send investors flocking toward the dollar?
The short answer is: don’t count on it. Markets have been signaling their distrust of Trump for months now. At this point, fear of a new crisis could precipitate capital flight away from the dollar, at which point the US would have to deal with a dollar crisis in addition to a potential military conflict.
Risk of a dollar crisis seemed minimal in the weeks immediately following Trump’s surprising electoral victory last November. In fact, by the end of last year, capital inflows had pushed the dollar up to levels not seen in more than a decade, owing to expectations of large-scale deregulation, tax cuts, and fiscal stimulus in the form of infrastructure spending and increased outlays for America’s supposedly “depleted” military. Economic growth, investors believed, was bound to improve.
But with the Trump administration now engulfed by scandals, the post-election “Trump bump” has faded, along with faith in the dollar. In the administration’s first 200 days, the dollar has lost almost 10% of its value. While Trump has been tweeting nonsense, investors have been looking for alternative safe havens in other markets, from Switzerland to Japan. This trend began before the US’s latest contretemps with North Korea, but it was only a trickle then. Now, that trickle is threatening to turn into a flood that will leave the dollar permanently damaged.
Of course, the Trump administration might actually want a weaker dollar, and to let others assume the role of global safe haven. But such an abdication would be historically – and dangerously – shortsighted.
The dollar’s popularity as a store of value confers an “exorbitant privilege” to the US. When investors and central banks place their wealth in Treasury bonds and other US assets, the US government can go on spending whatever it needs to sustain its many security commitments around the world, and to finance its trade and budget deficits.
With his transactional approach to politics, Trump seems to focus more on the costs of having a global reserve currency than on the advantages. But he cannot hope to “Make America Great Again” if he has to worry about capital flight, and he will not be able to enact his domestic agenda if he has to accommodate negative market sentiments abroad.
There will be nothing “great” about an America that has sacrificed its dominant position in the global financial system. If Trump tests the dollar too much, he will probably come to regret it.
The Elusive Benefits of Flexible Exchange Rates
There is no denying that flexible exchange rates provide valuable monetary-policy independence. But, in a dollar-dominated global trade environment, the ability of a floating currency regime to support full employment is severely limited.
CAMBRIDGE – In 1953, Milton Friedman published an essay called “The Case for Flexible Exchange Rates,” arguing that they cushion an economy from internal and external shocks by bringing about just the right price changes required to keep the economy at full employment. But after almost half-a-century of floating exchange rates, the reality is more complicated than that.
To understand Friedman’s logic, consider a scenario in which productivity in the United States rises. In an efficient system, this should reduce the price of US goods relative to those of the rest of the world, with US exports becoming cheaper than imports. As America’s terms of trade (the ratio of export prices to import prices) deteriorate, demand is shifted toward US goods, keeping the economy at full employment.
If prices are “sticky” (in the producer’s currency), however, a potential hitch emerges. Say the prices of US imports from Japan are sticky in Japanese yen and the prices of US exports to Japan are sticky in dollars. The terms of trade will thus remain unchanged, as long as the exchange rate does as well.
Here is where a floating exchange rate comes in. By enabling monetary expansion, and thus causing the US dollar to depreciate, the logic goes, a floating exchange rate allows the prices of US exports to decline relative to its imports. The result is the desired deterioration of the producer’s terms of trade and the maintenance of full employment.
But this line of reasoning assumes that a country’s terms of trade move in lockstep with its exchange rate. And that, as history over a quarter-century has shown, does not seem to be the case.
In a recent paper, the International Monetary Fund’s Emine Boz, Princeton’s Mikkel Plagborg-Møller, and I construct bilateral export- and import-price indices for 2,500 country pairs, covering 91% of world trade for the period 1989-2015. We exclude the prices of commodities (oil, copper, and other such goods that are traded on an exchange), as these prices are not sticky.
As it turns out, there is no evidence that the terms of trade and the exchange rate move in tandem. On the contrary, a 1% depreciation in the bilateral exchange rate is associated with only a 0.1% depreciation in the bilateral terms of trade in the year of the depreciation. The origin of this disconnect – which Camila Casas, Federico Diez, Pierre-Olivier Gourinchas, and I describe in a 2016 paper – seems to be that, for the vast majority of internationally traded goods, prices are sticky in dollars, not in the producer’s currency, as Friedman’s reasoning required.
Consider the case of the US and Japan. Almost 100% of US exports to Japan are priced in dollars, meaning that they, as in Friedman’s version, are sticky in dollars. But 80% of US imports from Japan are invoiced in dollars, meaning that those prices, too, are sticky in dollars, rather than in Japanese yen. As a result, the terms of trade change very little, even if the exchange rate fluctuates.
This means that, even if the US dollar depreciates, it does not become more expensive for US importers to buy Japanese goods, so there is limited incentive to switch from Japanese to US goods. A weaker dollar thus has limited impact on US imports. Likewise, a weaker yen does little to spur Japanese exports to the US, because the dollar price of those exports remains roughly constant.
This phenomenon applies even to trade transactions that do not include the US. As I documented in a 2015 paper, the share of world imports invoiced in US dollars is 4.7 times larger than the share of world imports involving the US. For world exports, that figure is 3.1. This “dominant currency paradigm” lies at the root of the terms-of-trade disconnect.
In fact, we document that global trade prices and volumes are driven by the dollar exchange rate, rather than the exchange rate between the two trading partners’ currencies. So fluctuations in the price and quantity of India’s imports from China, for example, depend on the rupee-dollar exchange rate, rather than the rupee-renminbi exchange rate. The strength of the US dollar is thus a key predictor of aggregate trade volume and consumer/producer price inflation worldwide.
Friedman was right about one thing: flexible exchange rates do provide valuable monetary-policy independence. But, in a dollar-dominated trade environment, their ability to support full employment is severely limited.