September 23, 2003

The Weak Dollar Policy

One of the many things Robert Rubin has been is a bond salesman. That, I believe, accounts for his "strong dollar policy"--Rubin's promise to people thinking of buying U.S. Treasury and other dollar-denominated bonds that the U.S. government was in the business of trying to keep the value of its securities high, and was not thinking of pursuing a policy of dollar depreciation that would boost exports while eroding the wealth of foreign bondholders.

But this Treasury Secretary is different. Over the weekend, Treasury Secretary John Snow persuaded the G-7 nations to issue a communique largely--and correctly--perceived as calling for a "market-based" rather than a "strong" dollar. In response, the value of the dollar fell. U.S. interest rates jumped. The stock market declined:

Markets Fall on Declining Dollar | Jerry Knight: The stock market skidded, the value of the dollar fell and interest rates today rose as financial markets responded to a weekend meeting of world economic leaders.

At the meeting in Dubai, representatives of leading industrialized countries in the Group of Seven proclaimed that markets rather than governments ought to determine currency values. Such a strategy is usually endorsed by most economists and governments, but the statement aroused concern that the dollar would fall in the future and thus make investments less attractive in American equities and debt markets.

The statement was aimed at China and Japan, which have been keeping the values of their money low because they believe it helps their economies. Japan in particular has been holding down the value of its currency, the yen, so that Japanese goods will be cheaper to buy in the United States and other markets.

When financial markets opened after the meeting, the value of the yen jumped to its highest level compared to the U.S. dollar in three years. Although the call for letting the markets determine the relative values of various nations' currencies was pushed by U.S. Treasury Secretary John Snow -- who believes it will be good for the U.S. economy -- the immediate response of the U.S. markets was negative.

The Dow Jones industrial average dropped 120 points from the opening bell and closed down 109 points at 9,535.41 -- its biggest daily loss in more than a month. The Standard & Poor's 500 stock index fell more than 13 points to 1,022.82. The Nasdaq Stock Market composite index dropped 31 to 1,874.62. In the bond market, interest rates on 10-year Treasury notes jumped by as much 13/100ths of a percentage point in early trading but recovered to end the day up by 8/100ths of a point--still an unusually large one-day move...

What is going on here? That question calls for an answer on two levels, economic and political.

On the economic level, the signals that the U.S. Treasury is no longer in the business of trying to keep foreign holders of U.S. Treasuries from suffering lots of exchange rate risk makes foreigners' investments in U.S. Treasury bonds riskier. As a result, foreigners will invest less in U.S. Treasuries and other dollar-denominate securities. Less money flowing into the U.S. looking for securities to buy means that the supply of capital flowing through U.S. financial markets will fall. Falling supply with constant demand means a rising price. The price of capital flowing through U.S. financial markets jumps--and that price is the interest rate.

Hence U.S. interest rates today rise in anticipation of a smaller flow of capital through U.S. financial markets. The stock market falls for similar reasons: some of the foreign demand for U.S. stocks that was expected to materialize in the future will simply not be there. And this rise in interest rates and reducing in equity values will reduce investment in America by a little bit.

In the long run of three to five years this reduction in investment spending below what it would otherwise have been will have few or no effects on employment. As dollar-denominated securities are perceived as riskier, the price of dollar-denominated securities in terms of other countries' assets falls as well--and that price is the exchange rate. A lower value of the dollar makes U.S. exports more attractive. And in the long run in which the economy settles at full-employment equilibrium, the foreign money that would have been invested in America is diverted and spent buying more of America's exports instead. Fewer jobs in construction and in capital-goods manufacturing. More jobs in export-oriented manufacturing. Employment-wise, it's a wash. Income-wise, it's a loss: America has worse terms of trade, and the lowered level of investment slows the rate of long-run economic growth. Safety-wise, it's a gain: growth in exports reduces America's trade deficit, and reduces the chance that large external debts coupled with domestic policy mistakes will produce a situation like East Asia in 1997 or Mexico in 1994 (or the U.S. in 1873).

The net long-run effect? Hard to say. The prospective boost to exports and reduction in the trade deficit reducing the risk of a future serious crisis is a plus. It would, however, have been much better for the long run if the prospective boost to exports were accompanied by a long-run reduction in consumption rather than investment (but that would require a different administration, one willing to raise taxes when it is in the national interest to do so). The prospective decline in investment and economic growth is an offsetting minus, as are the worsened terms of trade.

For the next two years, however, we live not in the long but in the short run. What are the likely short-run consequences of John Snow's communique? The lower value of the dollar will boost exports eventually, but the links and lags between the value of the exchange rate and the volume of exports are long indeed: it will be twelve to eighteen months before we begin to see the rise in export earnings relative to baseline produced by the communique. The higher interest rates produced by the communique will start to put downward pressure on investment spending in nine months or so--next summer. The likely effect of the shift to a weak dollar policy is to open up a hole in aggregate demand that will raise unemployment between one and two years from now. The Federal Reserve is almost out of the ammunition it could use to offset the effect of the shift to a weak dollar policy on interest rates, and the Bush Administration has used up the political capital that it could have used to persuade Congress to adopt a fiscal policy to boost employment in the short run.

So we see that things are weird. The last thing I would want to do--were I sitting in the Treasury Secretary's chair, or were I sitting in Karl Rove's chair--would be to depress investment spending and thus raise unemployment in the second half of 2004. Yet that's what last weekend's policy move seems tuned to achieve. Now so far the shift in dollar policy is not large. The movements in asset prices are small. The effects on the unemployment rate in September 2040 are small. Only if there are more signals that indicate that last weekend wasn't an ill-considered error but a substantive shift in policy will the movements in asset prices and in future investment become large.

Nevertheless, to push down stock prices when you are hoping for an investment boom to cure your business cycle malaise and to push up long-term interest rates just when the Federal Reserve is jawboning as hard as it can to try to keep them down--this is a very odd thing to do right now.

One possibility is that the Treasury Department--or, at least, the people in the Treasury Department who watch the markets--have been shut out of the decision making. "Let's use John Snow in Dubai to send a signal to Ohio and Michigan that we care and are trying hard to boost foreign demand for their exports," some deputy assistant to the president for political affairs (or equivalent rank) said. And when the appropriate Treasury assistant secretary (or equivalent) learned a week later and said "wait a minute" was told "we can't be nay-sayers: we have to be team players." Strong Treasury Secretaries run roughshod over White House Political Affairs on the grounds that policies that are good for the country are also the best long-run politics. Middling Treasury Secretaries who come from Wall Street and for whom the dance of expectations and the flow of finance are second nature challenge White House Political Affairs, on the grounds that they understand how the markets will react and what the big headlines will be. Weak Treasury Secretaries? Who are not from Wall Street and do not really understand why the financial markets do what they do?

Are there other possibilities? I can't think of any.

Posted by DeLong at September 23, 2003 09:23 AM | TrackBack


Good work, Mr. Snow. This administration does a very good job: diggin' their own grave. May it rest in peace on the 21st of January, 2005.

Posted by: Nescio on September 23, 2003 10:12 AM

Brad, we had this discussion a couple a days ago. Then you argued for this weaker dollar. Now when you have it you don't want it??

Posted by: Mats on September 23, 2003 10:27 AM

The other possibility is the Krugman hypothesis. The US is on the road to being a North American version of Argentina. It begins by screwing the foreigners who hold bonds. The real fun is later.

Posted by: P O'Neill on September 23, 2003 10:32 AM

So you're saying that this was politically motivated by a cynical administration?

Consider this Financial Times article:

"Other G7 officials said privately that the communiqué was more a bid to placate domestic US public opinion than a genuine attempt to engage with the Chinese authorities. A senior G7 official said there was resistance to treating China as the "root of all evil" and the country was very unlikely to succumb to public international pressure to revalue its currency."

"US and UK undermine exchange rate consensus"
by Alan Beattie and Christopher Swann in Dubai
Published: September 21 2003 19:31

Posted by: Barry Ritholtz on September 23, 2003 10:55 AM

could this be ideological? i don't know if i have read it completely right, but could this be part of the administration's weirdo isolationism? foreign investement somehow seen as more influencial in domestic affairs than foreign purchasing- kind of a continuation of the starvation of government, the starvation of institutions that keep us considering the global community.

i mainly ask because the adminstration seems so impractical- especially economically; whatever the reason, this seems to be a continuation of that theme.

Posted by: quinn on September 23, 2003 11:06 AM

In Europe they have Finance Ministers. The US has a Treasury Secretary. If the president does not understand the responsibilities, he may well hire the wrong person for the job.

The US has a history of putting MBAs or ex-CEOs in Treasury. Clinton did the same thing with Senator Bentson, before getting it right with Rubin and then Summers. What led Clinton to make his decision? Why does the GOP always turn to guys like Don Regan?

Was Clinton enough of an economics wonk to learn he needed a Finance Minister and not a CEO in Treasury?

Posted by: bakho on September 23, 2003 11:09 AM

Brad, so arguing that exchange rates should be set by the market equals a weak Dollar policy? Politics over rigor?

Posted by: Stan on September 23, 2003 01:13 PM

I get it. A weak dollar makes investing in Iraq more appealing.

Posted by: bakho on September 23, 2003 01:24 PM

I think it's more cynical than that. Bush reasons he is going to be reelected in states that rely on good old industrial exports. On the other hand, his advisors know very well that he stands little chance in most states where innovation is done and (net) investments are made. So, screw the progressive cities and ressusitate the industrial dinosaurs. And too bad if it hurts for America's growth prospects beyond 2004. God bless America...

Posted by: Jean-Philippe Stijns on September 23, 2003 02:32 PM

roach likes it! does everything have to be politically motivated? :D

as long as its "orderly" :D also andy xie thinks it's not really the end of intervention, convincingly, i think!

and lest i add, that an orderly depreciation of the dollar and ongoing asian central bank intervention are not mutually exclusive :D in the short run as they say, letting their currencies appreciate too much would be deflationary for japan et al and also nix much needed financing for our deficits on favorable terms for the US, not to mention all the cheap products we get!

so while the the dollar-intervention trade across the pacific is mutually beneficial, it's probably not going to go away overnite. but it's an unstable equilibrium, and i think what roach was getting at is that this is the first stab he's seen of moving it into a more stable and sustainable area. 1) it puts pressure to make needed reforms in japan and asia (and china) as well as make them less reliant on their export markets, while encouraging domestic demand and 2) it weens the US away from thinking there's ready, able and natural buyers for all that debt we're issuing and hopefully provides some relief for the woeful state of our current account :D it's a fair trade!

Posted by: dirk on September 23, 2003 02:46 PM

This was a good article!!! Writen by an Economist! History first; 3 years after every economical crash, 1920, 1929, 1974, 1987, 2000, there is a secound crash of between 20-45 percent of the current value of the market. We are getting very close to that point now. The economy could go; 1)Deflation (best long term solution) 2)1987-92 style 3)High inflation 4)Hyper-inflation. Economists and the FED fear Deflation the most. If the Dollar continues to decline over the next few weeks, and interest rates continue up, then we can forget Deflation. What I wanted to see for the last 20 odd years was for the government to Pay off the national DEBT, by cutting government departments and waste 150-250 billion, and The People would not have been effected. But how can you cut spending in an election year???? No Matter what party you'r in!!! This would have been the most painful way to go and against popular Economists opinion, But.. the best for the long term GOOD of America. ----Back in 90/91 when America tried to re-value the Yen, the rummer of Japan dumping the US Treasuries, stoped America at 70 Yen to the Dollar. China is in almost the same perdicurment. Maybe, the Dollar will go back to normal in a few days???

Posted by: Jim Coomes on September 23, 2003 06:11 PM

I tend to think that the dollar will come down substantially of its own accord over the next 2-4 years, for various reasons. However, in this case, talking down the dollar is indeed a dumb idea, for the reasons well explained in this post.

So why is the Bush administration going to do it? I agree with the possibility offered in this post (along with some other comments above): the only reason that they are considering it is for short-term political gain. In this they are acting consistently. After all,every other policy decision in this administration has been driven exclusively by short-term political calculations, regardless of whatever longer-term real damage the policy will inflict on the US. The economists (and finance people) have apparently been shut out of the decision-making loop since early 2001.

Posted by: Kash on September 23, 2003 06:45 PM

Jim Coombs- there is not $150- $250 billion to cut unless the debt is paid off and interest payments go to zero. Or there are cuts in defense budget or cuts in medicaid, or cuts of aid to the states. There is not much discretionary spending at all. IN FACT we could eliminate ALL discretionary spending and we would still be running a deficit. The idea that waste and fraud make up a large part of the Federal budget is pure myth. The items that commonly get cited as waste and fraud amount to less than 1% of the budget. That is not $150 to $250 billion. It may amount to a couple of billion. To eliminate $150-$250 from the Federal budget would require MAJOR CUTS in MAJOR Programs.

Personally, I think there is $100 Billion in the Defense budget that could be cut without causing problems with defense, but it would devastate important politically connected defense contractors that give lots of campaign donations to politicians on both sides of the aisle. That is not going to happen.

Posted by: bakho on September 23, 2003 07:06 PM

I would guess the Bush White House is looking at the trade deficits and is wanting to get those down. The lag between a weak dollar policy and a drop in imports should be relatively brief, and could stimulate domestic demand at the expense of demand for imports.

If the weak dollar policy were done well, and moderately, it could help to force the rest of the world to relax their tight money policies and spread the "engine of growth" (i.e., deficit spending) over a few more shoulders.

But when has Bush done anything well, or moderately?

Posted by: Charles on September 23, 2003 09:42 PM

Really, the overwhelming impression I get from reading the observations of real economists like Brad is that this administration's influential economic policymakers have about the same or less expertise in these matters as NRO. They operate from false but ideologically attractive economic "theories", and/or a partial and incorrect understading of current economic opinion (as is the case in this example).

It's really quite astonishing to me. I don't find it as hard to come to terms with the fact that we have such a radical and ideological administration, as I do the fact that they are so incredibly inept at almost everything they do. History has been very, very kind to this administration (as it has been to Bush himself), and people with that experience mistake accidents of history and chance with merit and real success.

Until the house of cards falls down. And I think all the signs are there of this happening in regards to almost every policy this administration has pursued, and, important to them, politically. Opinion is turning against them. And I am absolutely positive that within the White House, there is a great deal of shock and puzzlement over this unexpected turn of events. As Nescie says above, we should be thankful that this band of incompetents is being undone by their incompetency. We've been suffering through it, and suffering through a little bit more of their harmful and, ironically, self-defeating policies is a small price to pay for the long-term benefit of seeing them leave power after only one term.

Posted by: Keith M Ellis on September 23, 2003 10:04 PM

I think the attempt to bring the value of the dollar down is a bit more than 'kind words for the folks back home'. There is a tremendous consensus that the dollar is significantly over-valued. The latest in a long line of reports on this topic came with the last IMF Global Economic Outlook.

Krugman recently raised the spectre of Argentina. No one wants to respond to this kind of talk, but everyone is listening. He is after all, one of the most quoted exports on international currency and financial crises.

One way or another there's no avoiding some difficult decisions. It's either adress the problem now, and take it cleanly on the cheek, or have a bigger - almost unthinkable -problem later.

Brad is right, that normally politicians choose the latter option. But even this isn't working. The US hasn't stopped the jobs exodus. Ideally, sufficient growth in Europe and Japan would facilitate a 'band-aid' fix. But this may not be coming any time soon. Japan's recent 'recovery' is very much cap-ex lead, expecting to sell to the high-growth US.

On another front, China appears neither willing nor able to accommodate. In terms of the political dimension, how much of a confrontation with China can the US afford in a post Iraq war environment with North Korea still making worrying noises?

When you're trapped, and all the options are short-term bad, don't look for coherence.

I think the 'drop the dollar' talk is genuine. Remember if not, the threshold of deflation round about election time seems almost guaranteed (see Bernanke's recent speeches and look at the output gap). It's the other half of the equation I don't see, a strong euro and yen. Bottom line, anything can still happen, but it is all very unstable.

Posted by: Edward Hugh on September 23, 2003 10:24 PM

Two last thoughs. Firstly, as Brad points out, dropping the dollar will put a break on investment since it will raise long term interest rates. But what will it do to consumption? We know that reducing imports will mean 'less for more' for the US consumer, but what about the effect on mortgage rates, and if they rise, what happens to house prices? And if house prices take a negative knock what happens to private consumption. A difficult question, and probably not one for an election year, one up for Brad......

But (second thought), as Brad points out US debts are denominated in dollars. This then is not Argentina. So US citizens have some protection against the fall. But what about non-US citizens? Their loans are dollar denominated. The devaluation would be at their expense, and they must know this. It is a game of cat-and-mouse. But this means that when they expect a serious 'dollar correction' there may well be a rush for the door. This is what the US Treasury needs to avoid, and this is why they may, in fact, be serious.

As I said, don't look for consistency, just take your choice. Which do you prefer: to be shot, or to be garotted.

Posted by: Edward Hugh on September 23, 2003 10:57 PM

"There is a tremendous consensus that the dollar is significantly over-valued." - So I gathered, but I haven't yet seen any details on this so far, neither in mainstream media nor here. I strongly feel I shouldn't have to search much for what underlies this *tremendous consensus*.

But instead, it is the conflicting views that meets the eye, the Japanese obviously wants a weaker yen, and European officials have said that a Euro stronger than 1.20 would hurt. China OK, but it's an economy the size of Italy (Italy has by the way has a rapidly strengthening *real* currency, which few talk about), so should it matter that much?

Posted by: Mats on September 23, 2003 11:59 PM

Surely the weakness of the dollar is largely due to the easy money policy of Alan G (cheered on by economists like BDL and Krugman). If there are too many dollars, those dollars will be worth less.

Posted by: Andrew Boucher on September 23, 2003 11:59 PM

Surely the weakness of the dollar is largely due to the easy money policy of Alan G (cheered on by economists like BDL and Krugman). If there are too many dollars, those dollars will be worth less.

Posted by: Andrew Boucher on September 24, 2003 12:04 AM

claims that Canadian officals says that Snow's dollar gig was ordered by Greenspan. Don't know what those clams are worth though.

Posted by: Mats on September 24, 2003 12:44 AM

"details on this so far"

Try back numbers of the IMF outlook.Probably April. They put a 40% guesstimate if my memory serves me well.

'Greenspan ordered', this I doubt, at least in these terms. But it may well be that far from - Gauti Eggerston style - the central bank losing autonomy, what may be happening is that the US Treasury is losing hers. Greenspan and Bernanke do seem to have more idea about what is happening than most.

Posted by: Edward Hugh on September 24, 2003 02:07 AM

How time flies. IMF outlook, April 2002, Chapter 2.

Posted by: Edward Hugh on September 24, 2003 03:38 AM

I'm still looking for the substance behind the overvaluation claims on the dollar. Briefly searching chapter 2 of IMF World Economic Outlook April 2002
gave me nothing. Edward tells me 40% in April 2002, without quoting reasons, just names. And since then Yen has won about 30%, Euro about 20%, so most of that 40% should have been corrected by now. My question remains unanswered:

Why do you think the USD is overvalued, and against which world currencies (other than the Yuan, if you call that a world currency)?

Posted by: Mats on September 24, 2003 05:13 AM

but what about the effect on mortgage rates, and if they rise, what happens to house prices? And if house prices take a negative knock what happens to private consumption. A difficult question, and probably not one for an election year, one up for Brad......

I don't know. In the short term (3-6 months) I do not think that there will be that much of a change for a couple of reasons; there is extremely little equity left for consumers to extract at low rates, so refinancing activity is very low at the moment because interest rates have already bounced back from their historical lows. Secondly with the extremely low interest rates in the past, every marginal buyer should have been able to find something that they wanted to buy, so I do not see a lot of demand in the market. Thirdly, a lot of people who want to buy houses in the near term probably have interest rate locks already guaranteed.

In the medium term, I can see a decrease in both refi activity as the new long term rates will be higher than the rates that people have locked in, and less buying as sellers start seeing that they are getting negative equity on their houses. I think that most people buy houses not on the present value of the structure, but on the monthly payment, so with higher rates, the values of the offers for houses will decline.

In the long term, I do not know enough to speculate intelligently.


Posted by: fester on September 24, 2003 06:36 AM

Does OPEC raising the price of oil have to do with a weaker dollar?

Oil is traded in $$ and a weaker $ means less foreign currency for OPEC so they recover by raising the price?

Doesn't increase in the price of oil increase the trade deficit? Could this get cyclical?

Posted by: bakho on September 24, 2003 06:45 AM
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