The almost continuous decline in the value of the dollar since the middle of 2002 has catapulted the foreign exchange value of the dollar to the forefront of financial discussions and editorials. Inferences are being derived from a negative relationship between the trade balance and the foreign exchange value of the dollar which could easily lead people and policymakers down a bearish path. This should be avoided at all costs.
One fear running amok these days is that in order to improve the trade balance, the terms of trade (i.e., the dollar) will have to decline substantially. Another fear is that if the improvement in the trade balance does not occur fast enough, the fall in the dollar needed to affect the improvement may degenerate into a financial crisis.
Some policymakers may be tempted to accelerate the adjustment process by devaluing the currency. That is a major mistake; a monetary devaluation leads to higher inflation. Usually the accompanying economic measures associated with the devaluation lead to a slower growth rate of real gross domestic product, which in turn leads to an outflow of capital. This is quite a bearish outlook. However, it is by no means the only one.
Another interpretation of events is that current conditions point to a healthy and growing economy, one in which inflation is well under control. The stock market has reacted strongly to the reelection of President Bush and presumably his proposals for the “ownership society.” The performance of the economy and the stock market simply do not match the outlook forecast by the dollar bears.
So, if the outlook is bullish, why is the dollar weak?
The path the economy takes to reach a new equilibrium depends on numerous factors. Nevertheless, at any point in time, the value of the exchange rate may reflect adjustments to previous and current market conditions.
It is easy to see this in two cycles of appreciation in recent economic history. One begins around 1983-84 when the Reagan tax rates were being implemented. The other begins in 1995 when the Republicans took over Congress.
There are two views of these cycles that tell the same story. The first is that early on in each cycle, the U.S. economy behaved like a growth stock. Investors, both domestic and international, flocked to the U.S., and the capital inflow produced a higher stock market. The second view is that early on in each cycle, as net worth increased relative to disposable income, the U.S. trade balance began to worsen.
But each time the U.S. outperformed the rest of the world.
As investors try to acquire dollars to invest in the U.S., the dollar appreciates above its purchasing power parity (PPP) value. Over time, as investment continues, the rate of return in new investments declines and eventually the rates of return go back to their long-run equilibrium. PPP is once again restored.
Since the use of a price rule (which the Federal Reserve appears to be using today) essentially eliminates monetary disturbances as the source of exchange-rate fluctuations, it follows that the bulk of the fluctuations in the dollar will reflect the U.S. terms of trade or relative rates of return. Thus, early on in an economic cycle, as the rate of return increases, the dollar appreciates. However, if PPP is to be restored, the dollar will have to experience a round trip. More important, use of the price rule will insure that the fluctuations in the dollar will not alter in any significant way the underlying inflation rate.
Today we are feeling the effects of the dollar returning to its long-run equilibrium for the cycle that began when the Republicans took over Congress. At first this appears to be a rather long cycle, but looking at the Reagan years, one can see that it is not unique. The dollar is fast approaching its PPP level, and if President Bush carries through with his “ownership society” programs, we are in for another long prosperous cycle.
In a way, the U.S. has been acting like a growth company — with household net worth at an all-time high today and the economy expanding at a healthy pace. If the rest of the world adopts pro-growth policies, capital will flow their way and their trade surpluses will decline — even becoming trade deficits if they are successful enough. This would truly be a case of a rising tide lifting all boats. The world economy would soar.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.