The Dangers Created by the Dollar’s Dominance

by Reihan Salam

According to Ryan Avent of The Economist, the U.S. dollar’s rapid appreciation in the early 2000s, the result of mercantilist currency manipulation on the part of several of America’s trading partners, led to a steep increase in the relative cost of American tradable goods. This in turn did a great deal of damage to the U.S. economy:

What would we expect to happen in such a circumstance? Well, we would expect a big blow to industries that were cost-sensitive and highly exposed to foreign markets. We would expect to see large current-account deficits and for net trade to be a substantial drag on growth. We might anticipate that the central bank would struggle to boost demand given weakness in external demand, and we might expect that efforts to boost demand would overwhelmingly work by lifting growth in non-traded sectors.

And that is pretty much exactly what happened. The Fed is often accused of having created a bubble to spur domestic demand, and thus creating the conditions for a housing bust and a financial panic. Yet Avent, drawing on new work from economists Doug Campbell and Ju Hyun Pyun, suggests that what the U.S. really ought to have done is intervene in foreign-exchange markets to dampen or even reverse dollar appreciation. Campbell and Pyun find that the dollar had an effective appreciation of 48 percent from 1990 to 2002, which led to a dramatic spike in relative unit labor costs. Not surprisingly, this led to a steep decrease in manufacturing employment in manufacturing industries exposed to foreign competition. There is nothing wrong with exposing U.S. manufacturers to vigorous foreign competition. There is something wrong with standing idly by as foreign central banks force currency appreciation that puts U.S. manufacturers at a disadvantage that has little to do with their managerial prowess. 

Avent argues that the U.S. ought to reconsider its reluctance to intervene in foreign-exchange markets, as depreciations have a strong track record as a tool for lifting expectations for growth and inflation while substantial currency appreciation appears to have a strong contractionary effect. If anything, Avent maintains that “not intervening to weaken the dollar is by far the more dangerous policy approach,” as the alternative is a Fed that has no choice but to create financial bubbles to achieve full employment at home. Directly weakening the dollar is, in Avent’s view, “the surest way to escape the current doldrums.”

One concern is that if the U.S. were to intervene in foreign-exchange markets, it would jeopardize its role as the world’s primary reserve currency. According to Avent, the opposite is the case: if weakening the dollar offers an alternative to constant bubble-creation, the dollar will become a safer asset, thus reinforcing the dollar’s dominant role. But I wonder if moving away from the dollar’s role as the world’s primary reserve currency might actually be a good thing, as Michael Pettis has argued.

For Pettis, the dollar’s dominance in the global monetary system is not an “exorbitant privilege.” Rather, it is an “exorbitant burden” that forces Americans to bear substantial costs:

When foreigners actively buy dollar assets they force down the value of their currency against the dollar. U.S. manufacturers are thus penalized by the overvalued dollar and so must reduce production and fire American workers. The only way to prevent unemployment from rising then is for the United States to increase domestic demand — and with it domestic employment — by running up public or private debt. But, of course, an increase in debt is the same as a reduction in savings. If a rise in foreign savings is passed on to the United States by foreign accumulation of dollar assets, in other words, U.S. savings must decline. There is no other possibility.

So where is the privilege in all this? Ask any economist to describe the greatest weaknesses in the U.S. economy, and almost certainly the list will include the gaping trade deficit, the low level of savings, and high levels of private and public debt. But it is foreign accumulation of U.S. dollar assets that, at best, permits these three conditions (which, by the way, really are manifestations of the same condition) and, at worst, causes them to deteriorate.

The U.S. needs to take action to force other major economies to share in this burden. Avent’s prescription — that the U.S. ought to intervene in foreign-exchange markets to resist efforts to drive up the dollar’s value — is an excellent first step.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.