Even with that sexy buildup, I fear this sounds technical and stodgy, but give me a chance. What’s going on with the dollar these days is fascinating, and as you’ll see, we’re not really taking a break from politics at all, as President Trump is breaking with long-held dollar-policy precedence.
Most people think of the value of the dollar in purely domestic terms, as in what it can buy at the store. But in international terms, what matters is the exchange rate: how much is the dollar worth compared to other currencies. How many euro or yen or renminbi do you get for your dollar? That’s the exchange rate question, and it too plays a significant role in what you can buy at the store, as the exchange rate plays a key role in the dollar price of imports, not to mention inflation. And once you invoke inflation, you’ve invoked Federal Reserve policy. Most recently, the value of the dollar has even shown up in our tax policy debate.
In conventional economics, the dollar’s exchange rate is determined by a wide variety of factors. Relative growth rates, and relatedly, interest rates, between countries are important. In fact, faster U.S. growth and higher U.S. rates have been partially responsible for the 25 percent increase in the value of the dollar since mid-2014. For all Trump’s talk of American “carnage,” our economy is growing faster than other advanced economies, and importantly, in contrast to central banks in Europe and Japan, our Fed is raising rates.
Trade flows play a role as well, as strong demand for our exports will also push up the dollar and vice versa. The logic is simple: If the Malaysians want to buy American goods, from peanut butter to bonds, they need dollars, and that demand pushes up the dollar’s value relative to the Malaysian ringgit. This might suggest that countries with trade surpluses would have stronger currencies than those with trade deficits, but here’s where things get tricky, especially in the age of Trump.
In the 2000s, China’s trade surplus with us grew sharply, yet their currency failed to appreciate at all. The reason, known to all, is that China’s yuan is officially pegged to the dollar. The figure below shows the dollar/yuan ratio since 2000 plotted against the dollar/euro ratio, just to show you how obvious the peg was. For both better and worse, this is the era that team Trump appears to have learned about dollar policy, and they’ve not updated their priors since, despite the fact that the peg has often been relaxed since then.
Models assuming that pure market fundamentals fully determine exchange rates are thus woefully incomplete and naive. Currencies are undervalued in countries across the globe, from Japan to Germany to Korea and Singapore, and governments often play a role in keeping them that way.
Why would they do so? Remember, when we’re talking exchange rates, we’re talking the value of your currency relative to mine, as in euros to dollars, and if yours is undervalued, then by definition, mine is overvalued. (An analysis by Bill Cline of the Peterson Institute recently found the dollar to be overvalued by 11 percent.)
Trump and his trade team must get partial credit for surfacing a real issue that political elites have too often ignored: When countries manipulate exchange rates, they make their exports to us cheap and ours to them more expensive. This, in turn, exacerbates our trade deficit and, in the U.S. case, accelerates the loss of factory employment. (Our trade deficit is wholly in manufactured goods; we run surpluses in services.)
All of which brings us to this pretty remarkable thing Trump said the other day in the Wall Street Journal:
“Our dollar is too strong. … Having a strong dollar has certain advantages, but it has a lot of disadvantages.”
Now, that may sound pretty uncontroversial, and with Trump, there’s always the highly germane question of whether he actually means what he says. But for decades, presidents and their treasury secretaries have refused to say anything other than, “The U.S. supports a strong dollar, full stop.” They may not have always believed that to be the best policy, but their motivation in saying it was to not influence currency markets. While understandable in theory, in the real world, where countries frequently engage in currency management, that’s akin to unilateral disarmament.
Yet despite Trump’s acknowledgment of a strong dollar’s downside, his team’s currency views are stuck in the period a decade ago, shown in the figure above. Whereas former administrations were too deferential to both market forces and the multinational corporations that benefit from running large trade deficits, the Trump crew assumes every currency move is evidence of manipulation. If anything, most analysts believe China’s currency today is being propped up (i.e., prevented from falling). Forthcoming depreciation in the yuan, and my personal forecast is that it will fall further this year, will likely be largely a function of slower Chinese growth, capital outflows and uncertain expectations over what a China-bashing Trump administration means for their economy.
I give Trump credit for surfacing the importance of the dollar, though ironically, the dollar has climbed 3.5 percent since the election, making it tougher to reduce the trade deficit. But the policy goal should not be to somehow artificially push back against this appreciation. It should be to block countries from using their trade surpluses to buy up more dollars (and dollar-based assets) in order to gin up exchange rate movements that help them and hurt us.
As I point out here, there are good ways and bad ways to push back on currency management. But my main point is this: Keep track of the dollar, as it has got a lot of important information to impart.