The U.S. dollar needs to depreciate, Dilma

Last week, I referred you to an incoherent attack on American monetary policy by Brazilian president Dilma Rousseff. She argued that “economies that issue reserve currencies,” i.e., the United States, “are resorting to undervalued exchange rates to ensure their share of global markets.”

There are two basic errors with this claim. First, the only reason the dollar is the world’s reserve currency is because other governments—including Brazil’s—want it to be. No one forced the Brazilians to buy $200 billion of U.S. assets over the past five years. Second, the U.S. dollar is not undervalued. If it were, we would be earning large current account and trade surpluses. Instead, we run deficits.

Dilma had it backwards. The United States has not been taking advantage of the rest of the world—it is the rest of the world that has been taking advantage of us. The only way to peaceably resolve the imbalances that have resulted from decades of protectionism by the surplus countries of the world is through a large depreciation of the U.S. dollar.

There are plenty of countries that manipulate their exchange rates to subsidize domestic production. Most of them are in East Asia, although the Swiss and the Norwegians are also guilty.

With the exception of the Nixon Shock of 1971 and the Plaza Accord of 1985, the United States has generally avoided depreciating the dollar on purpose. In fact, most of the currency interventions executed by the Treasury’s Exchange Stabilization Fund and the Federal Reserve’s open-market operations were meant to prop up the value of the dollar, usually against the yen and German mark.

For perspective, this has been the history of the broad, trade-weighted U.S. dollar index (not adjusted for differentials in inflation rates or productivity):

Ms. Rousseff is upset about the small decline highlighted in red at the end. Considering that it is Chinese manufacturers, not American ones, that are driving Brazilian companies out of business, her position is quite puzzling.

The dollar is not under-valued in any normal sense of the word. A more interesting question is whether a cheaper dollar would actually put a dent into the global imbalances that have been distorting American savings patterns. Some, particularly apologists for the Chinese mercantilists, believe that currency adjustments cannot affect what they claim are “structural” deficits.

They neglect to point out that the exchange rate between two currencies that would lead to balanced trade constantly changes. This is because the real effective exchange rate is a function not just of the nominal exchange rate but also changes in relative productivity and relative prices.

If inflation is faster in the U.S. than in China but the dollar does not fall to offset this, U.S. goods become more expensive relative to Chinese goods than they were before. Likewise, productivity grows far faster in China than in the U.S. because the Chinese are still catching up to our level of development. This means that the yuan ought to be steadily appreciating against the dollar simply to prevent the deficit from widening further.

To illustrate how these forces combine in practice, consider the case of Japan, which has much more reliable historical data than China and originated the development strategy that many now associate with its neighbor.

This chart shows the yen/dollar exchange rate since 1973 from three different perspectives: the official nominal rate, the nominal rate adjusted for changes in relative prices, and the nominal rate adjusted for relative prices and relative productivity growth (a reasonable proxy for the real effective exchange rate).

In real terms, the yen is no more expensive than it was in 1986. Consider that the next time you read an article about how the yen keeps hitting new highs against the dollar.

Does the price of the dollar affect the trade deficit? Yes. The next chart shows the real effective yen/dollar exchange rate against the bilateral U.S.-Japan trade deficit as a share of U.S. GDP (right axis, inverted). Notice the remarkable stability of the relationship between the two variables:

The U.S. current account deficit currently sucks about $600 billion out of the economy every year. Right now, it is a drag on business investment and a major contributor to the U.S. government deficit. The cause: a dollar that is grossly over-valued thanks to protectionist manipulation in foreign countries.

Why do we put up with it? Nixon didn’t. Reagan didn’t.


This is not investment advice. A cheaper dollar is a clean solution to the world’s imbalances but that does not mean that you can expect to make easy money betting on the dollar losing value. The Korean won is now worth significantly less, in nominal dollar terms, than it was 20 years ago, even though Korea transitioned from a middle-class to a rich country during that period. The mercantilists and protectionists of the world are determined to keep manipulating their currencies below the fair-value market exchange rate. They will not be persuaded to alter their policies by appeals to their better nature.


About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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