Can Bush Save the Dollar's Fall?

by: Menzie Chinn

Figure 1: Log real trade weighted value of dollar against a broad basket of currencies (blue) and against major currencies (red). Note: Squares are March figures accessed on March 12. Source: Federal Reserve Board.

"Bush Would Like a Stronger Dollar" - That's the title of a post in today's WSJ RealTime Economics:

President George W. Bush said in an interview today with Nightly Business Report that the dollar's fall to record lows against the euro is not a good thing and he "absolutely" wants a stronger dollar. Excerpts:

Q: You mentioned that one of the reasons that's driving up the price of oil is the dollar. You have said that you are for a strong dollar. Do we have a strong dollar now?

Bush: We have a dollar that's adjusting, and I am for a strong dollar. One reason I am for a strong dollar is because I want, you know, people to -- I think it helps deal with inflation. And you're right, the weakening dollar has affected our capacity to be able to purchase energy. I mean, we're dependent on energy from overseas. Our dollar doesn't buy as many barrels of oil as it used to, and so therefore it's more expensive for the American people. And that's why I'm for a strong dollar; one reason.

Q: But the dollar is down against the euro, something like 45%, over the last six years. And today it hit a new low against the euro.

Bush: No, I know. And it's not - those aren't good tidings, if you're for a strong dollar like I am.

Q: Would you like a stronger dollar?

Bush: I would, absolutely. And there are certain things that we can do. We can send signals to the world that their capital is welcomed into the United States, that we'll fight off protectionism, and that we'll deal with this -- you know, the dollar was strengthened when people realized the relative strength of our economy. And one of the things people are watching carefully is, will the United States government put policy in place to stimulate growth without affecting long-term growth? In other words, without passing laws that make it harder for investment, or harder for capital to move, or harder for markets, labor markets, to remain flexible.

I think that President Bush has a good insight in focusing on long-term growth as a determinant of the dollar's path. In particular, I want to highlight the fact that the dollar's decline began before the Fed starting slashing interest rates. In Figure 2, I plot the real value of the dollar against major currencies and the US-euro area real interest differential (the interbank rate minus lagged one year inflation). Even as the US-euro area real interest differential increased in 2005-06, the dollar was declining. At that juncture, I asked: What happens when US policy rates stop rising? We know the answer now.


Figure 2: Log real trade weighted value of dollar against a basket of major currencies (blue) and nominal interbank interest rates adjusted by lagged 12-month CPI inflation (red). NBER defined recession dates shaded gray. Source: Federal Reserve Board, NBER, IMF International Financial Statistics, and author's calculations; January Euro Area HICP from ECB.

Why is the dollar declining? I think part of it is the interest rate effect (which is driven by Taylor rule fundamentals). Part of it is the portfolio balance effect (dollar denominated assets are just plain less attractive relative to a couple years ago, when some observers were waxing eloquently about deep and liquid US financial markets). But I want to stress two effects less often remarked upon.

  • Wealth effects
  • Trend GDP effects

Wealth effects: Amidst all this talk about losses being incurred, I think there is the belief that someone's gain is another persons loss. That's partly right. But I also think that perceived wealth is shrinking; as this occurs, consumption decreases. Since US consumption is biased toward US goods, this means the dollar should weaken.

In addition, while some people have hailed the fact that the Net International Investment Position [NIIP] in dollar terms has not declined as a share of US GDP over the past few years, I want to note that as the dollar has declined, US income and wealth measured in terms of what it takes to buy foreign goods has declined [0]. (Exogenous terms of trade effects including higher real oil prices also reduce net wealth).

Trend GDP effects: What's been little remarked is that anticipated trend growth, as measured by median estimates of expected 10 year growth rates, has declined from 3.3% in February 2005, to 2.75% last month (median responses from Survey of Professional Forecasters, February 2005 and February 2008). This development can be linked to the dollar's trend trajectory in two ways. First, wealth is sometimes thought of as the present discounted value of an income stream (so this is independent of the "wealth effect" insofar as there is some failure in rational expectations, or there are distributional effects). Second, a big chunk of the revision to GDP growth is due to a revision in anticipated productivity growth; this has ramifications for the real exchange rate either through the Balassa-Samuelson effect, or through some other channels (see this post).

Bottom line: The "adjusting" dollar is, of course, partly a consequence of the monetary policy that is now being implemented. But it would be wrong to ascribe all of the dollar depreciation to the Fed's policies. I'd say that -- when considering the sources of the dollar's decline -- think of what policies induced year after year current account deficits [1]; think about what policies (or failure to enforce laws) allowed the subprime mortgage debacle to occur [2]; think about what policies encouraged consumption and discouraged national saving (the sum of private saving and budget surplus) [3]. Something to consider when contemplating this quote in Bloomberg:

"The dollar looks in real trouble and there is no obvious resistance level against the euro," said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. "I don't think you can pick a level for where it will stop."