Dollar puzzles

Did I learn nothing at all at university? I’m prompted to ask by the increasing tendency – of which the BBC is part – to blame the falling dollar on the US’s budget deficit.

This view not only flatly contradicts efficient market theory – we’ve known about the federal government’s red ink for ages – it also contradicts the standard exchange rate models we learnt in the 1980s. These are the Mundell-Fleming-Dornbusch models. In these, a fiscal expansion strengthens the currency, because it boosts economic activity and raises the demand for money.

This is exactly what happened in the early 1980s. Reagan’s budget deficits were associated with a soaring dollar in 1981-85.

So, how can we blame the budget deficit for the falling dollar this time? There are (at least) four things that might be wrong with the standard Mundell-Fleming-Dornbusch model. However, two of them are obviously inapplicable today, one is uncertain, and the other doesn’t justify current talk about the dollar. These are:

1) Ricardian equivalence. A budget deficit is just deferred taxation. If the private sector saves in anticipation of higher future taxes, economic activity and the demand for money won’t change, and so the dollar won’t rise. Obviously, though, this doesn't apply now. These figures from the BEA show that the personal sector’s saving ratio has fallen to just 0.2 per cent.

2) Deteriorating creditworthiness. If foreign investors take fright at rising government debt, they’ll sell bonds and trigger a fall in the currency. Again, though, this hasn’t happened, at least not yet. These figures show that foreign private investors (never mind central banks) bought $167.3bn of US government debt in the 12 months to September.

3) Fiscal reform and long-run growth. In the mid-1980s several governments (such as Ireland) slashed government borrowing and reduced taxes and saw incipient strength in their currency as a result. This is because tax reform raised long-run economic growth prospects. Perhaps the opposite applies today. Maybe the foreign exchange market is selling the dollar because it anticipates that rising future taxes will depress long-run growth. But is there any evidence that this really is the case?

4) All systematic exchange rate models are useless. Since the early 1980s academic economists have known that all the major theoretical models rarely fit the facts and have poor forecasting properties. This is the Meese-Rogoff puzzle, recently updated by Menzie Chinn here. (For obvious reasons, private sector forecasters don’t talk about this). On this view, though, there’s just little coherent that we can say about the dollar.

For these reasons, it’s hard to see how the budget deficit is responsible for the weak dollar. Which raises the question –why do people say it is?

One possibility is that this is just another example of the representative heuristic. People naturally believe that one “bad thing” is caused by another “bad thing.”

More respectably, some people are using the weak dollar to draw attention to the fact that Americans will have to increase their savings sometime.

And herein lies the problem. If or when Americans do start to save more, the resulting slowdown in demand could weaken the dollar still further, and cause even more trouble for people exporting to the US.

Comments

[Peter]

As I understand the argument, it is that a worryingly high budget deficit produces a big capital account surplus. A big one of those means a big current account deficit, which will for all the usual reasons mean a depreciation in the dollar.

[Robert Schwartz]

www.nytimes.com/2004/12/15/business/worldbusiness/15deficit.html

In Today's NYTimes:

"The European Commission froze its threat of fines against France and Germany on Tuesday, granting the two biggest economies in the euro zone an extra year to bring down their bloated budget deficits. . .

In October, the commission forecast France's budget deficit next year to be exactly 3 percent of gross domestic product. Germany's was forecast to reach 3.4 percent. . ."

Of course this explains why the Euro is so high.