What is Wrong with a Weak Dollar?

Nothing, if you ask me - in fact it is the natural equilibration mechanism of the world economy and right now the very weak dollar is helping make US exports competitive abroad.  Brazil, right now, faces the opposite problem, the Real is so strong (thanks in large measure to the boom in commodities prices) that it is getting harder for Brazilian exporters to compete.  My experience in flying to São Paulo last fall was a flight from Chicago stuffed with Brazilians and their many purchases from US stores, while the flight home was somber - many Americans broke from a short stay in the metropolis.

Brazil faces troubling inflation and sagging exports.  The response to the former - tighter monetary policy - will increase interest rates and further the appreciation of the Real.  Both will slow down economic growth.  In the US, a weaker dollar and very low inflation will help speed the tepid recovery and keep a lit on imports as consumers will be daunted by their high prices.

But none of this is well understood among the average US worker, and perhaps the governments reluctance to talk openly about it is the culprit.

In the New York Times this weekend, Christy Romer argues that the government should speak more frankly about exchange rates and how they affect the economy:

Some countries, like China, essentially fix the price of their currency. But since the early 1970s, the United States has let the dollar’s value move in response to changes in the supply and demand of dollars in the foreign exchange market. The Treasury no more determines the price of the dollar than the Department of Energy determines the price of gasoline. Both departments have a small reserve that they can use to combat market instability, but neither has the resources or the mandate to hold the relevant price away from its market equilibrium value for very long.

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...Perhaps if government officials could talk about the exchange rate forthrightly, there would be more understanding of the issues and more rational policy discussions.

Such discussions would start with some basic economics. The desire to trade with other countries or invest in them is what gives rise to the market for foreign exchange. You need euros to travel in Spain or to buy a German government bond, so you need a way to exchange currencies.

The supply of dollars to the foreign exchange market comes from Americans who want to buy goods, services or assets from abroad. The demand for dollars comes from foreigners who want to buy from the United States.

Anything that increases the demand for dollars or reduces the supply drives up the dollar’s price. Anything that lowers the demand for dollars or raises the supply causes the dollar to weaken.

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But in a depressed economy, it isn’t so clear that a strong dollar is desirable. A weaker dollar means that our goods are cheaper relative to foreign goods. That stimulates our exports and reduces our imports. Higher net exports raise domestic production and employment. Foreign goods are more expensive, but more Americans are working. Given the desperate need for jobs, on net we are almost surely better off with a weaker dollar for a while.

I encourage you to read the entire essay at the Times. For other coverage of the benefits of a weak dollar, here is the Planet Money folks at NPR (oh how I hope NPR will move away from the folksy economics coverage) and USA Today.

Oregon's Exports and Trade Weighted Exchange Rates

In the wake of my little post on Oregon's trade weighted dollar index, Josh Lehner at the Oregon Office of Economic Analysis' Blog discusses it in depth and points us to the index that his office keeps. Here is an excerpt:

Given Oregon’s industrial makeup (the state’s manufacturing location quotient for 2009 was 1.143, with durable goods registering a 1.309) and geographic location, the state has long been a major exporter and international trade is a pillar of the state’s economy. According to research, Oregon is the fifth most trade-dependent state in the U.S. and a recent Brookings Institute report (see page 15) shows that the Portland-Vancouver MSA is the second most trade-dependent metro in the country behind only Wichita, KS. (Wichita is the “Air Capital of the World” and has long been a major player in the aircraft industry with operations by Boeing, Airbus, Leerjet and Cessna, among others.) Seeing that exports play a major role in Oregon’s economy and international trade is influenced by exchange rates, tracking the international competitiveness of Oregon’s exports is important to determine the economic health of the state and also to help gauge future trends. It also stands to reason that for a trade-dependent state, such as Oregon, a dollar index is a leading indicator for local employment. As the dollar becomes more competitive, it will boost Oregon exports, which in turn will lead to increased employment as the exporting firms need to hire additional workers to fill orders and the ports will hire additional workers to load/unload the products onto ships, barges and airplanes.

Generally speaking, what the Dallas Fed is now undertaking follows the methodology of our office’s Oregon dollar index, however there are a few differences that lead to slightly different outcomes. First, the graph below illustrates our office’s Oregon dollar index and the Major Currency dollar index from the Federal Reserve over the past 15 years.

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The fact that the Dallas Fed uses the Top 25 trading partner countries and our office uses just the Top 15 countries may seem like a potentially large difference, however, based on data over the past 15 years, it is not. On average, the Dallas Fed notes that their indexes cover 89 percent of all exports for each state. That means, the Top 25 trading partners account for 89 percent of each states’ exports. In Oregon, the Top 15 trading partners account for an average of 84 percent of all exports and depending upon the year, the exact percentage falls within the 82-88 percent range. With such a small difference between using the Top 15 compared to the Top 25, the overall dollar index for the state would not be changed significantly.

Overall, the continued depreciation of the U.S. dollar and also the Oregon Dollar Index, is good news for exports (and manufacturers of export goods), which should continue to increase as the global expansion continues.

Go read the rest of the post there.

Mankiw on Exchange Rate Policy

A nice piece on exchange rate policy by Greg Mankiw appeared in The New York Times over the weekend.

Here is an excerpt:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

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Make the country’s economy open to international flows of capital. Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.

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Use monetary policy as a tool to help stabilize the economy. The central bank can then increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated.

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Maintain stability in the currency exchange rate. A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.

In the United States, we have picked the first two. Any American can easily invest abroad, simply by sending cash to an international mutual fund, and foreigners are free to buy stocks and bonds on domestic exchanges. Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.

By contrast, China has chosen a different response to the trilemma. Its central bank conducts monetary policy and maintains tight control over the exchange value of its currency. But to accomplish these two goals, it has to restrict the international flow of capital, including the ability of Chinese citizens to move their wealth abroad. Without such restrictions, money would flow into and out of the country, forcing the domestic interest rate to match those set by foreign central banks.

Most of Europe’s nations have chosen the third way. By using the euro to replace the French franc, the German mark, the Italian lira, the Greek drachma and other currencies, these countries have eliminated all exchange-rate movements within their zone. In addition, capital is free to move among nations. Yet the cost of making these choices has been to give up the possibility of national monetary policy.

The European Central Bank sets interest rates for Europe as a whole. But if the situation in one country — Greece, for example — differs from that in the rest of Europe, that country no longer has its own monetary policy to address national problems.

Is there a best way to deal with this trilemma? Perhaps not surprisingly, many American economists argue for the American system of floating exchange rates determined by market forces. This preference underlies much of the criticism of China’s financial policy. It also led to skepticism when Europe started down the path toward a common currency in the early 1990s. Today, those euro skeptics feel vindicated by the problems in Greece.

To this I would only add that the US doesn't have such a hard choice, as the Dollar is an international 'hard' currency we don't have to worry os much about exchange rate fluctuations as most contracts our businesses write with international counter-parties are in dollars.  True, those counter-parties will agree to terms that take exchange rate risk into account, but it is a small issue relative to a small country where exchange rate volatility can be devastating.  

Econ 101: Exchange Rates

What determines the exchange rate? The simplest answer is supply and demand. Suppose you are sitting in England and have some savings in pounds and want to buy an asset in the US. To do so, you must sell your pounds for dollars because US based assets are priced in US dollars. This raises the demand for dollars and increases the supply of pounds - leading to an increase in the exchange rate between dollars and pounds. It now takes more pounds to buy dollars than it did before.

The New York Times has a nice article on the rising dollar. In it the author stresses the flight to safety - foreigners are snapping up US Treasuries. This is good for the government, because it keeps the cost of borrowing money low. But the rising dollar is bad for US exporters (and Oregon is one of the states most dependant on exports) because it raises the price of US goods abroad. So people and businesses from all over the world that are worried about loaning money to just about anyone, will still loan to the US government because it has the lowest risk of default of any entity out there. Since it takes dollars to buy treasuries, this raises the demand for dollars and increases the supply of just about every other currency. Voila, a rising dollar.

But it is not just the demand for US treasuries that is causing an appreciation in the dollar (though surely it explains most of the rise), there are also some other anecdotal snippets, like this story about foreigners snapping up houses in Detroit. If Australians and Brits are coming over here to but property, they are bringing with them their own currencies and will have to convert them to actually make a purchase which reinforces the appreciation of the dollar against those currencies. 

Economist's Notebook: From the Southern Hemisphere

Greetings from Sao Paulo. Two interesting snippets from yesterdays O Estado do Sao Paulo (one of the Sao Paulo daily newspapers).

First this for my students of international economics and money and banking:

Luckily for me, the US Dollar has appreciated against the Real considerably - making my stay here much cheaper. Each of my dollars buys more stuff here than it did a few months ago. For example the 50 Reais meal I had yesterday would have cost me $31 at the beginning of September and now costs me about $21. Here is the Dollar-Real exchange rate history for the last three months:



This appreciation of the Dollar is bad for US exporters to Brazil, because now the same goods are more expensive to a Brazilian. It should be good for Brazilian exporters for the opposite reason. But much of Brazil's trade is in primary products (65% of the total value of Brazil's exports according to the article below) and while the Real has been depreciating, the worldwide economic crisis has caused commodities prices to plummet. So Brazil is hurting, here is the banner headline from the Sunday paper:

Crise em países ricos e queda de preços abalam exportação
Valor de matérias-primas, que lideram venda externa, caiu 42% desde julho

By the way, currency depreciations for developing countries are usually bad news if they have dollar denominated debt (which many do), but defending currencies is usually an expensive and risky game.  This, however, is a topic for another time.  

A couple of side notes. I was amused that the newspaper headline called the economic crisis a "crisis in rich countries," this is true, the banking crisis did originate in the US and Western Europe, but, as is noted by this article, the crisis will affect everyone. It is also amusing that they would use the term rich countries as we are so careful to use euphemisms like "developing countries" instead of "poor countries."

Second, as a soccer fan I was very interested to see an article on the latest hot youth bands in Sao Paulo include pictures of two very hip new and hot bands wherein one member of each band was wearing a soccer jersey from the US's Major League Soccer. For those that wonder what non-pecuniary benefits an MLS team might have for Portland, here it is - worldwide exposure. And, by the way, this is why I think MLS is a good long term investment for the Mssrs. Paulson - entering into a global sports marketplace in a way that even the NBA does not have a prayer to match has got to be a good bet.

Econ 101: Inflation, Exchange Rates and Commodities

Though I try and stick more to the local and the personal in this blog, I thought it might be a good time to try a little primer on international finance, as I just taught it in my international economics class. Call it the "what the heck is going on?" post.

I am going to borrow a pedagogical device right out of Krugman and Obstfeld's outstanding text and start with an asset either in Europe or the US. What determines the performance of this asset? Well, interest rates and inflation if you are investing domestically. If you are investing from abroad, however, exchange rates matter as well. But it is not what the state of the world today that matters most for the performance of an asset, it is what the state of the world will be in the future - when the asset matures - that matters most. Thus expectations about inflation and exchange rate movements matter a lot. This is why central banks have become more and more transparent: they are trying to manage expectations. This is also why central banks have become, first and foremost, inflation hawks: they want to guarantee low inflation lest investors get jittery.

So let's get back to that asset. Suppose you are in Europe and you have money to invest and you are thinking of investing in either a euro denominated asset or a US dollar denominated asset. If interest rates in the US are high, you might be tempted to invest in the dollar asset, to do so you want to sell euros and buy dollars so you can purchase the asset. Since many investors are making the same calculation the demand for dollars will be driven up and demand for euros will be driven down. This will lead to an appreciation of the dollar. Higher interest rates in Europe, all else equal, will have a similar effect: the euro should appreciate against the dollar (or dollar depreciation). Inflation in either zone will lower the real return on the asset and thus will have the same effect as lowering the nominal interest rate and thus high inflation in the US should lower the demand for dollar assets and lead to a depreciation of the dollar. Finally, expectations about exchange rates can lead to them being self-fulfilled: if you expect the dollar to depreciate this leads to a lower demand for dollar assets (because when it matures the dollars you get out are now worth less) and thus a lower demand for dollars and - hey presto! - a dollar depreciation.

With this basic framework in hand, it is not surprising that the US dollar has depreciated so remarkably over the last few years - the fed kept interest rates low which both lowered the return on dollar assets and caused a bit of concern about inflation. Here is a picture of the dollar-euro exchange rate for the last five years:



Commodities play in interesting role here, especially if they are dollar denominated (which most are). Generally when the US dollar depreciates it makes US products sold abroad cheaper to the residents of those foreign countries. It also makes foreign products more expensive in the US. This generally leads to more exports being sold and fewer imports being bought which - in the US - would generally lower the trade deficit. However oil is a dollar denominated commodity, and since we import a lot of it, our trade deficit is actually going up (see graph from NY Times). Since oil prices are set in a futures market they are a function of expectations of future supply and demand and exchange rates. So questions about future supply and a weak dollar have pushed up oil prices dramatically, something we are seeing filter down to the gas pump. There could also be quite a bit of speculation as well, but it is not yet clear that this is the main culprit. Add to this the fact that food prices are climbing ever higher and that the crop year does not look to be particularly bountiful and you have even more pressure on inflation.

So where does this leave us today? Well, the US is in the midst of a major economic slow-down sparked by the credit crisis. The credit crisis, while still needing a long time to shake out, looks to have been largely tamed by some bold action by the Fed. Now we are faced with some unpleasant realities for the near future. The price of oil is starting to seep into core (non-energy and food) inflation. If wages start to respond (which as of yet they haven't), we could be in for a major inflationary episode. This will cause the dollar to further decline which will mean even higher oil prices. Yikes. So regardless of how the credit market is currently faring, the Fed will almost certainly have to start to raise interest rates. Doing so will quell inflation expectations and drive up demand for dollars which should start leading to an appreciation of the dollar. But it will also cause a slow down in domestic investment at the very time we want more of that to happen. Still the risks are much worse: once wages start adjusting to inflation, the Fed will have to respond much more drastically to keep inflation under control.

So, over the next 12 to 24 months I think we are in for a very tough time. The Fed will almost definitely start to raise interest rates, appreciating the dollar and taking some pressure off commodities prices. This will, unfortunately, curtail credit at the very time we are trying to get credit flowing again which will lengthen the malaise in the housing market. So right now the Fed knows it needs to stay on top of inflation but definitely does not want to jump the gun as the longer they with the more the credit markets can recover before increasing rates. I think we are likely in for a long and painfully slow recovery.

Hold on to your hats...

Economist's Notebook: Exchange Rates

In my international economics class right now, we are talking about exchange rates - what determines them and what their effects are.

Well, I am in Bellingham, Washington to give a talk this afternoon at Western Washington University and the effects of the recent exchange rates are quite visible here - it is quite amazing. Bellingham, being about 20 miles south of the Canadian border on I-5, is over-run with Canadians. They fill the restaurants, apparently pack the malls and the long-term parking lot the little airport here was abut half Canadian cars.

Why such an invasion? Well, here is a picture that tells the story. This is a graph of the Canadian dollar to US Dollar exchange rate. So in 2003, a Canadian Dollar would buy about 73 US cents, now it buys a full US Dollar.



The Canadian dollar has appreciated rapidly against the dollar in the last year. For Canadians, US restaurants, stores and airline flights in US dollars are suddenly a bargain. Here is an easy example. Look on almost any book you buy here in the US. Mine for this trip is the Swedish police procedural The Dogs of Riga by Henning Mankell, a book in the Kurt Wallander series (great series, by the way). The cover prices are $13.95 US and $16.95 Canadian. Well with the US and Canadian Dollars trading one for one (as of today) this book is $3 cheaper if you are a Canadian and buy it in the US. It is no wonder all these Canucks are in Bellingham!