TCS Daily


Dollar Drama, Dollar Delusions

By Arnold Kling - December 20, 2004 12:00 AM

"In the absence of effective leadership by either the US Treasury or the International Monetary Fund, there is every prospect that the dollar's recent steady decline will soon turn into a rout."
-- Desmond Lachman

So what?

Alarm about America's international economic statistics is the last refuge of hand-wringers. When the best story that the worry-warts can point to is the trade deficit and a declining currency, it is a sign that the economy is in good shape. It's like waking up to a front page headline on sports scandals. I am relieved whenever I turn on the radio and find the airwaves dominated by Jason Giambi's steroid confessions or Ron Artest's pugilistic exploits, because then I know that nothing really horrible is going on in the news.

Whose Trade Deficit?

Many journalists treat the merchandise trade balance as a sort of basketball score. If we are importing more goods and services than we export, then we are losing, and conversely. As an economist, I find the sports analogy misleading. Economists view trade primarily as an efficiency tool, like using word processors instead of typewriters or tractors instead of horse-drawn plows.

I would tend to measure the state of our trade by looking at our exports plus our imports rather than as exports minus imports. The more we trade, the more efficiently we will be using our domestic productive resources. It makes more sense to worry about the total volume of trade than about the difference between exports and imports.

George Mason University economist Don Boudreaux even wonders whether the concept of a national trade deficit has any significance. He writes

"Suppose that government starts collecting trade data on blonde-haired people.

The government could then calculate the "blonde current-account" and the "blonde capital-account" - that is, reporting the value of blondes' purchases of goods and services from brunettes, redheads, grey-heads, and other non-blondes..."

Boudreaux argues that trade is between individuals. As an individual, you can run a trade deficit by consuming more than your income. Assuming that you had no savings to start with, this means that you will have to buy on credit, and you will have a debt to repay eventually.

Suppose that you do not run a personal trade deficit, but that other people with the same hair color or the same nationality do run such a deficit. Why should you care? Unless you agreed to be responsible for other people's debts, those debts should not affect you.

If the trade deficit exists because your government issues lots of debt that is bought by foreigners, then that can affect you. Eventually, the government is going to tax you to pay off the debt. But that is primarily an issue of how the government runs its fiscal policy, and the international aspect is only incidental.

Fluc'ed Again

The other major international indicator for the United States is the value of the dollar. It makes sense to worry about the exchange rate if you are a currency trader, in which case currency fluctuations will affect the performance of your holdings. It reminds me of a joke my late father-in-law used to tell about a broker who keeps ascribing the poor performance of his client's portfolio to market fluctuations. The exasperated client finally says, "Yeah, I know -- fluc'ed again."

The main driver of currency movements over the long haul is relative inflation rates, which in turn reflect money creation. If year after year the Mexican government keeps the supply of pesos constant while the U.S. government raises the supply of dollars by 10 percent per year, then on average the dollar will tend to lose 10 percent of its value per year to the peso.

At this point in history, inflationary money creation is not an issue for most major countries. Therefore, fluctuations in the value of the dollar reflect transitory shifts in international asset preferences.

For many years, foreigners seemingly were not able to get enough of U.S. assets, so that the dollar appreciated. When foreign demand finally tapered off in the past two years, the dollar declined. As readers of my book know, some of us were not surprised at this development.

Taking as given government policy for spending, taxes, and money creation, there is nothing specific that political leaders can contribute to the operation of the foreign exchange markets. We should just leave the currency speculators alone, including foreign governments, such as China's, that engage in currency speculation. Our government has no more business manipulating the value of the dollar than it does manipulating the betting odds on next week's football games.

As a typical American, how does a dramatically lower value of the dollar affect you? It makes certain consumer goods more expensive. It also subtly affects the outlook for employment in different industries. Compared with two years ago, the likelihood has increased slightly that you will work in an industry whose goods and services are traded internationally. By the same token, you are slightly less likely to work in an industry whose goods and services are insulated from international competition.

Economists often use foreign vacations as an example of tradable goods and haircuts as an example of goods that are insulated from international competition. As the value of the dollar goes down, more Americans will decide to vacation at home, and more Europeans and Asians will find it attractive to vacation in the U.S. The higher cost of imported goods will cut into Americans' incomes, so that we will have to conserve on haircuts (or other nontradables).

This expenditure-switching between tradable and nontradable goods has real costs, because it requires people to adjust to new industries. However, whether these costs are large or small is an open question. My own belief is that, relative to the tremendous churn in the U.S. labor market -- several million workers change jobs each month -- the phenomenon of expenditure-switching is not such a big deal.

Even if the costs of expenditure-switching amount to more than just rounding error in the overall economy, they are far from catastrophic. If you could promise me that the biggest threat to the U.S. economy in the next several years is a sharp decline in the value of the dollar, then I would promise you that our continued prosperity is assured.


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