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The dollar is soaring. Here’s what that should tell us about the economy.

Ben Bernanke is debasing the dollar! The currency wars are underway! Weimar awaits us!

So goes the chorus of financial chatterers every time the latest wave of monetary easing takes shape. But here’s the thing: The dollar is actually on a bit of a tear. Since the start of February, the greenback is up nearly 5 percent against six other major currencies. And the reasons why says a lot about how the world economy is evolving.

The dollar is on a tear! (This is the dollar index, its value against six other major currencies).

In short, the U.S. economy is looking a bit better. And the other world economies are sucking wind. Just today, new data from the European Union showed that  in the 17 countries that use the euro currency, employment fell to its lowest level in seven years in the final months of 2012. In other words, things are even worse for workers in Europe than they were in the immediate aftermath of the 2008 crisis. Britain is in what may well be a triple-dip recession. Japan has a new government trying to implement aggressive new measures to halt its decades-long economic slide.

Those are the explanations for why value of the euro has fallen from $1.36 to $1.29 since the end of January, the pound has fallen from $1.58 to under $1.50 today, and the Japanese yen has been tumbling steadily since before its December elections.

In other words, as terrible as the economy here may feel, it could be a lot worse. And importantly, while government policies (particularly by central banks) certainly have a lot of power to influence exchange rates, the core reality is this: The value or the dollar or any other currency hinges on the economic outlook for the country that uses it.

In other words, the tendency to view the value of the dollar as a referendum on how Ben Bernanke and Jack Lew are doing their jobs on any given day misses a lot. If the economic outlook improves, whether because of policies enacted in Washington, or because of the natural resilience of the U.S. corporate sector, or because somebody finds a Saudi-sized heretofore unknown oil reserve in the middle of Kansas, the dollar will rise. A key part of the reason that the dollar would rise on that improved outlook would be that investors expect the Fed to raise interest rates more and sooner than they would otherwise. But this is a case where the Fed is the cart, and the economy is the horse.

What has happened in the last few months is essentially a more modest version of exactly that. The housing rebound and generally solid private sector has evidently been enough to keep growth on a steady path, so dollars look like a comparatively better investment than the alternatives around the world.

At times, the tendency to conflate the strength or weakness of a currency with the strength or weakness of the nation is problematic. It can lead to bad policy if, for example, policymakers in a country with a terrible economic situation are unwilling to take steps to help because they fear allowing their currency to decline.

But strip out that emotionalism, and this teaches a fundamental lesson for policymakers: If you take care of your country’s economic prospects, the value of your currency will take care of itself.



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Neil Irwin · March 14, 2013

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