Tuesday, December 15, 2009

Why a stronger dollar is not a problem (2)

It's amazing to me that the market seems awfully concerned about the recent rise in the dollar's value. This chart shows what is arguably the best measure of the dollar's value against a large basket of currencies, since it is both trade-weighted and inflation-adjusted. At the end of November the dollar was trading (for the fourth time in history) at its lowest level ever. Today it is up about 3% from that low. How can this possibly be construed as a bad thing?

Those who worry about a stronger dollar are making several mistakes, and here are a few:

1) An ever-weaker currency does not lead to a stronger economy by way of boosting exports. Big downward moves in a currency can eventually lead to rising exports (the J-curve effect), but a depreciating currency also makes imports more expensive. Spending more on imports can offset whatever benefits there may be from rising exports.

2) An ever-weaker currency inevitably leads to rising inflation. The basic definition of inflation is a decline in the value of a nation's unit of account. Rising inflation throughout the economy can more than offset whatever gains there may be in the export sector.

3) An ever-weaker currency discourages investment, and without investment it is very difficult for living standards to rise. Who wants to invest in a country whose currency is falling? A depreciating currency can wipe out investment gains.

4) A weaker currency not only discourages investment, it encourages price speculation. A weaker dollar has helped boost commodity prices, and that in turn attracts commodity speculation. Speculative activities do not necessarily create a more productive economy, and many times they simply result in a transfer of wealth. Speculators play a very important role in keeping markets liquid and efficient, but when everyone starts speculating on price increases, you know that fewer people are paying attention to the investment that is essential to boosting the productivity of labor. The good thing about a strong and stable currency is that it reduces the rewards to price speculation, and that in turn forces the market to direct its resources to productive investments.

5) The dollar's rise from all-time lows is at least partially due to the expectation that the Fed will begin raising interest rates sooner than previously expected. Higher interest rates, coming off a base of zero, can hardly be considered a threat to economic activity. On the contrary, higher interest rates directly benefit the majority of U.S. households, since the household sector has significantly more floating-rate assets (e.g., bank CDs and money market funds) than floating-rate debt (e.g., adjustable rate mortgages, now at risk of extinction). Interest rates would have to be hugely higher for a long time—and the yield curve inverted—before they posed a serious risk to economic growth.


Louis Cyphre said...

Mr. Grannis, very clear. I wish you would try to explain that to policymakers and the public in Argentina, who still believe devaluations (the bigger the better) are the key to becoming a rich country.

Scott Grannis said...

If devaluations were good, Argentina would be one of the richest countries in the world. That it's suffered immensely instead, is one more reason why we in the US shouldn't be worried about a stronger dollar.

How many more times will the government bureaucrats in Argentina make the same mistake of devaluing the currency? It's simply mind-boggling to me. Yet our politicians keep making the mistake of pursuing Keynesian stimulus policies that never work.

Unknown said...

I agree, Aiso a stronger dollar is better for everyday people and a weeker dollar is better for corporates,stock investors..ie. lower gas prices( and commodities) vs more exports