NBER WORKING PAPER SERIES

WHAT'S NEXT FOR THE DOLLAR? Martin S. Feldstein Working Paper 17260 http://www.nber.org/papers/w17260 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 July 2011

The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. 2011 by Martin S. Feldstein. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

What's Next for the Dollar? Martin S. Feldstein NBER Working Paper No. 17260 July 2011 JEL No. E3,F0,F31,F4 ABSTRACT The real trade weighted value of the dollar fell 11 percent against the Federal Reserve Banks index of major currencies during the 12 months through May 2011 and 31 percent during the past ten years. Four strong market forces are likely to cause further declines over the next several years: a portfolio rebalancing by major international investors who regard their portfolios as overweight dollars, the large US current account deficit, a Chinese policy to raise consumption, and interest rate differences that make dollar investments less attractive. A declining dollar could have a powerful positive effect on the short-run performance of the American economy by raising exports (now more than $1.3 trillion) and inducing American consumers to shift from imports to American made products and services. Without a boost to demand from an increase in net exports, the U.S. recovery is likely to remain weak and could run out of steam. There are of course also negative effects of a falling dollar: reducing the real value of any given level of personal incomes by raising the cost to households of the imported products that they consume and creating inflationary pressures as import prices rise. Martin S. Feldstein President Emeritus NBER 1050 Massachusetts Avenue Cambridge, MA 02138-5398 and NBER msfeldst@nber.org

WhatsNextfortheDollarJuly2011

WhatsNextfortheDollar? MartinFeldstein* Whenitcomestothevalueofthedollar,theofficialmantraoftheUSgovernmentis thatastrongdollarisgoodforAmerica.Officialmantrabutnotofficialpolicy. NeithertheU.S.governmentnortheFederalReservedoesanythingtostrengthen thedollarortopreventitfromfalling. AmoreaccuratedescriptionofAmericanpolicyistohaveastrongdollarathome andacompetitivedollarabroad.Astrongdollarathomemeansalowinflationrate thatmaintainsthepurchasingpowerofthedollardomestically.Thisisclearlythe goaloftheFederalReserveandonethathasbeenachievedreasonablywelloverthe pastthreedecadeswithanaverageinflationrateofthreepercent. Incontrast,thecompetitivenessofthedollarabroadrequiresadeclineinthetrade weightedvalueofthedollartomakeU.S.exportsmoreattractivetoforeignbuyers andforeigngoodslessattractivetoAmericanconsumersbyreducingtherelative priceofAmericangoodsandservices.Thedollarhasinfactfallenoverthepast severaldecadesandfallensharplyinthepastyeardespitethemantrafavoringa strongdollar.Andthefallintheinternationalvalueofthedollarhasnotprevented maintainingthelowinflationrateathome. Herearethefacts:Inthe12monthsthroughMayofthisyear,therealtrade weightedvalueofthedollarfell10.6percentagainsttheFederalReserveBanks indexofmajorcurrenciesand9.1percentagainstthebroaderindexofcurrencies thatisalsocalculatedbytheFederalReserve. Thegovernmentswillingnesstoallowthisrapiddeclineofthedollarandperhaps eventoencourageitbyurgingtheChinesetocausethedollartodepreciaterelative totherenminbiandbytheFedspolicyofquantitativeeasingshowsthatU.S. dollarpolicyismoreaboutachievingacompetitivedollarthanaboutastrong internationalvalueofthedollar. Thesameistrueifwelookatthedollarsperformanceoveralongerperiod.Over thepasttenyears,therealtradeweightedvalueofthedollarfell31percentagainst theindexofmajorcurrenciesand26percentagainsttheFederalReservesbroader indexofcurrencies. *ProfessorofEconomics,HarvardUniversity.ThispaperisbasedontheAnnual LecturefortheBankforInternationalSettlements,deliveredJune23,2011in Lucerne,Switzerland. 1

TheFuture Butwhatofthefuture?Therearefourmajorreasonswhythedollarislikelyto continuefallingforatleastthenextfewyears.NotethatIamnotadvocating policiestomakethathappen.Iamjustlookingatthefundamentaleconomicforces thatIbelievewillcausethatcontinueddeclinetooccur. Theprimaryreasonisthatmajorinvestorsaroundtheworldwantfewerdollarsin theirportfolios.ThemajorfundmanagersinAsia,intheMiddleEast,andelsewhere whoareresponsibleforsovereignwealthfundsandfornationalpensionfunds generallybelievethattheyareoverweightdollarsandwanttodiversifytheir portfoliosawayfromthatoverconcentrationondollarsecurities. Thosegovernmentsaccumulatedlargeamountsofforeignexchangeasaresultof tradesurpluses.Insomecountriesthiswasthecausedbyundervaluedexchange ratesthatledtoincreasedexportsandreducedimports.Intheoilproducing countries,itwastheresultoftherapidriseinthepriceofoil.Therelevantofficials inthosecountriesinitiallyregardedtheseforeignexchangeholdingsastraditional reservestobeheldasawayofbridginganyfuturegapbetweenthecostofimports andthecountrysexportearnings. Eventually,however,thesecountriesrecognizedthattheydidnotneedsuchlarge amountsofforeignexchangetobridgethetemporaryimportexportgapsthatmight ariseinthefuture.Korea,Taiwan,Singaporeandotherswithmorethan$200 billioninforeignexchangeeachcametounderstandthatonlyasmallportionofthat wasneededforthetraditionalpurposeofforeignexchangereserves.Thatiseven morerelevantforthemajoroilproducingcountriesandforChinawith$3trillionof foreignexchange. Oncetheyrecognizedthatthesewerereallyimportantnationalinvestmentfunds, theyaskedthemselvesinwhatcurrenciestheyshouldbeheld,inwhatassetclasses, inwhatmaturities.ThetraditionalinvestmentinshorttermU.S.treasurybills ceasedtomakesense. Sotheybeganshiftingoutofthedollarandintoothercurrencies.Theprimary currencythattheyboughtwastheeuro.AlthoughfundsalsowentintotheSwiss franc,theAustraliandollar,theNorwegiankronerandothersmallercurrencies, onlythemarketforeurobondswaslargeenoughtoabsorbsubstantialshiftsof funds.Theresultofthisportfolioshiftwastoreducethevalueofthedollarrelative totheeuroandtotheothercurrencies. Thisdiversificationintotheeurowastemporarilyhaltedbythestartofthecrisisin Greeceandtheotherperipheralcountries.Theresultwasafalloftheeurorelative tothedollarandothercurrencies.Butafterawhiletheseinvestorsrealizedthatthe problemofGreeceandtheotherperipheralswasnotaproblemoftheeuroassuch butoftheindividualcountrieswithexcessivenationaldebtsanddeficits.They 2

concludedcorrectlythattheseproblemsshouldbereflectedintheinterestrate spreadsandinthecostofcreditdefaultswapsratherthaninthevalueoftheeuro. Sotheeurobeganrisingagain,increasingfromabout$1.35pereuroto$1.50.The morerecentconfusionanduncertaintyabouttheresolutionofGreecesneedfor additionalcreditandaboutthemoreremotepossibilityofdefaultsinSpainandItaly temporarilyreducedtheeurobacktoabout$1.40.But,inmyjudgment,itwillstart risingagain.TherecentreportsthatChinahasinvestedsomethreefourthsofits increasedforeignassetsthisyearineurosisconsistentwiththispatternofrenewed portfolioreallocation. Predictingthattheeurowillcontinuetorisemayseemtoignoretheveryhigh pricesthatanyonewhonowtravelstoFranceorGermanymustpay.Itiseasyto concludethattheeuroisfullyvaluedandnotlikelytoincreasefurther.Thiscasual empiricismissupportedbyofficialgovernmentcalculationsofpurchasingpower comparisons.Butbothbitsofevidencearemisleading.Whatmattersaretheprices thatdrivecurrentaccountbalances.Thepricespaidbytouristsareonlyasmall partoftherelevantpriceoftradeables.Andthepricecalculationsofgovernment officialsdonotaccuratelyreflectthequalitydifferencesasjudgedbyconsumers.So whilegovernmentstatisticiansmaybelievethatGermancarsareexpensiverelative toAmericancars,consumersaroundtheworldareclearlywillingtobuyGerman luxurycarsattheirexistinghighprices.ThatsoneofthereasonswhyGermanyhas acurrentaccountsurplusofnearly$200billion.Inshort,theapparenthighpriceof Europeangoodsandservicesisnotareasonwhythedollarwillnotcontinuetofall relativetotheEuropeancurrencies. ThesecondreasonthatthedollarwilldeclineistheenormoussizeoftheU.S. currentaccountdeficit.Duringthelast12monthsthemerchandisetradedeficitwas $680billion(morethanfourpercentofUSGDP)andthecurrentaccountdeficitwas $470billion.Shrinkingthatlargecurrentaccountdeficitcanonlybedoneby reducingthevalueofthedollarrelativetothecurrenciesofothercountries. TheUnitedStatesisamajorexporterwithexportslastyearofmorethan$1.3 trillion.Amorecompetitivedollarwouldincreasethevolumeofexportsandreduce thevolumeofimports. Whichcurrenciesareabletoriserelativetothedollar,leadingtoadeclineoftheUS currentaccountdeficit?Theeuroisagainthenaturalcandidate.TheEurozone representsalargecapitalmarketandhasacurrentaccountdeficitofonlyonehalfa percentoftheEurozonesGDP.Othercountriesthathavelargecurrentaccount surpluses,implyingthattheyhavetheroomtoabsorbtheeffectofacurrency increase,includeChinawithacurrentaccountsurplusofmorethan$300billion, Japanwithacurrentaccountsurplusofnearly$200billion(causingtheyentorise despitetheproblemsoftheJapaneseeconomy),Switzerlandwithacurrentaccount surplusof$80billiondespitethestrengthoftheSwissfranc,andthekeyAsian

countriesSingapore,TaiwanandSouthKoreathattogetherhaveacurrent accountsurplusofmorethan$100billion. Inshort,thelargeUScurrentaccountdeficitandthecorrespondinglargecurrent accountsurpluseselsewhereprovideanaturalpressureforthedollartodecline relativetothoseothercurrencies. Thethirdreasonthatthetradeweightedvalueofthedollarwilldeclineoverthe nextfewyearsisChinasnewgoalofincreasingconsumerspendinginChina. AlthoughChinasrapideconomicgrowthhasledtoasubstantialincreaseinthe standardoflivingofChinesehouseholds,thelevelofconsumerspendinghasnot increasedasrapidlyasChinasoverallGDP.Thenewtwelfthfiveyearplancallsfor ariseinconsumptionasashareofGDP,plusincreasedgovernmentspendingon consumerserviceslikehealthcareandeducation. ThisinturnwillimplyadeclineinChinasenormousnationalsavingrate,estimated tobeover40percentofChinasGDP.Sinceanycountryscurrentaccountsurplusis thedifferencebetweenitsnationalsavinganditsnationalinvestment(i.e., investmentinbusinessstructuresandequipmentandinhousing),Chinasveryhigh savingrateallowsittohavebothaveryhighinvestmentrateandacurrentaccount surplusofabout3.5percentofitsGDP. IfChinasnetsavingratefallsbyjustfourpercentofitsGDP,Chinascurrentaccount surpluswillendandwillchangetoacurrentaccountdeficit.Anendtoitscurrent accountsurpluswouldmeanthatChinawouldnolongerbeanetbuyerofforeign securities.Untilnow,ChinahasbeenthelargestlendertotheUnitedStatesto financeourcurrentaccountdeficit.IfChinawillnolongerbebuyingdollarsin ordertoinvestindollarbonds,thedollarwillfall. Moreover,ifChinawantstocontinuetomakerealinvestmentsintherestofthe worldbuyingoilintheground,agriculturallandinAfrica,businessesinvarious westerncountries,etc.itwillhavetobecomeanetsellerofsomeofits$3trillion offoreignsecuritiesprimarilydollarsthatitcurrentlyowns.Thatmeansfurther downwardpressureonthedollar. AlthoughthefallinthedollarthatwouldresultfromthereducedChinesedemand fordollarsneednotmeanafallinthedollarrelativetotherenminbi,theChinese governmentspoliciesarelikelytocausethatriseintherenminbidollarexchange rate.Therenminbiisofcourseacontrolledexchangerate.ThegovernmentofChina hasallowedtherenminbitoriserelativetothedollarbyabout5.5percentoverthe past12months.Butsincethedollarwasfallingduringthistimerelativetotheeuro, theyenandothercurrencies,thetradeweightedvalueoftherenminbididnotrise overthisperiod. Duringthepastyear,theChinesegovernmentpreventedafasterriseofthe renminbirelativetothedollarbecauseitwantedtoprotectChineseexport 4

manufacturers.ButincomingyearstheriseinspendingbyChineseconsumersand bytheChinesegovernmentwillsubstituteforthereducedvalueofnetexportsthat occursasChinascurrentaccountsurplusdeclines. TheChinesegovernmenthasbeenreassuringitsdomesticmanufacturersthatitwill notlettherenminbijumpsharplyassomeforeignershaveadvocated.Butithas alsomadeitclearthattherenminbiwillcontinuetoriseandithasadvocatedthat itsmanufacturersshiftproductiontoproductsforthedomesticmarket. TheimplicationofallthisisthatChinacannowallowtherenminbitorisemore rapidly.ThereisalsoafurtherreasonwhytheChinesegovernmentisnowlikelyto lettherenminbirisefaster.TheincreaseddomesticspendinginChinawillincrease demandandraiseinflationarypressures.Astrongerrenminbiwouldoffsetthese inflationarypressuresintwoways.ByincreasingtherelativecostofChinese exports,astrongerrenminbiwillreducethedemandforthoseproductsand thereforelimitthatsourceofinflation.Astrongerrenminbialsoreducesimport costs,includingthecostsofrawmaterialsthatareusedinChineseproduction. Thisbringsmetothefourthandfinalreasontoexpectthedollartocontinue decliningoverthenextfewyears:therelativelylowlevelofrealinterestratesinthe UnitedStates.BecauseoftheweaknessoftheUSeconomy,theFederalReservehas settheshorttermfederalfundsrateatnearzeroandpromisedtokeepitatthat levelforanextendedperiodoftime.Basedonthispromiseofcontinuedlowshort rates,multiyearratesarealsoverylow.Afterallowingforcurrentandexpected inflation,theimpliedrealratesarenegative. Incontrast,theECBhasraisedtheshorttermrateandindicatedthatitwillraiseit further.TheECBneedstodothisinordertopreventimportedinflationfromfood andenergypricestriggeringapricewagespiralinEuropesheavilyunionized economy.IntheUnitedStates,wagesarenotrisingandunionshardlyexist.Only7 percentofprivatesectorworkersareunionized.Sotherealinterestgapwillwiden, makinginvestmentinshorttermeurobondsofGermanyorFrancemoreattractive thaninvestmentinthecorrespondingUSbonds. Insummary,therearefourreasonstoexpectthatthedollarwillcontinuetodecline relativetotheEuroandothermajorcurrenciesoverthenextseveralyears:a portfoliorebalancingbyinvestorswhoregardtheirportfoliosasoverweightdollars, acontinuinglargeUScurrentaccountdeficit,aChinesepolicytoreducenetexports, andinterestratedifferencesthatmakedollarinvestmentslessattractive. Itisofcourseimpossibletosayhowfastthedollarwilldecline.Althoughitmayfall onlygradually,itcouldcontinuetofallatthe10percentrateofthepast12months orevenfasteriftheholdersoflargedollarinvestmentswanttoexittheirpositions toavoidthelossesthatwillresultfromthedollarsdecline.

Howlikelyisthat?Chinaisofcoursereluctanttoreduceitsdollarpositionrapidly becauseoftheadverseeffectthatwouldhaveonthedollarRMBexchangerate.In contrast,smallercountriesandprivateinvestorscouldshiftfromthedollartoother currencieswithoutcausingasignificantimpactonthevalueoftheirdollarexchange rates.ButifeachofthesecountriesKorea,Taiwan,etcwantstomovebefore sellingbyotherscausesthedollartodeclinefurther,thecumulativeeffectastheyall trytodosocouldbeasharpdeclineofthedollar.AndifChinaseesthatcoming,it mightwanttomovemorerapidlytoshrinkitsdollarposition. TheEffectoftheDollarDecline Adecliningdollarwouldhaveapowerfulpositiveeffectontheshortrun performanceoftheAmericaneconomy.Acontinueddeclineofthedollarwillraise thecurrentannualexportsofmorethan$1.3trillionandwillinduceAmerican consumerstoshiftfromimportstoAmericanmadeproductsandservices.Although exportsarelessthan10percentofU.S.GDP,morethanonethirdoftheincreasein USGDPoverthepastfourquarterswasaccountedforbytheincreaseinexports. Withoutaboosttodemandfromafutureincreaseinnetexports,theAmerican recoveryislikelytoremainweakandcouldrunoutofsteam,leadingtoanew downturnofGDP.AlthoughtheU.S.recessionofficiallyendedinthesummerof 2009,theexpansionsincethenhasbeenveryweak.Inthefirstthreequartersof 2010GDPgrewatanannualrateofjust2.7percentandmorethanhalfofthat increasewasjustinventoryaccumulationratherthanfinalsales.Althoughthe fourthquarteroflastyearsawatemporarysurgeofconsumerspending,this improvementoffinaldemandandGDPdidnotfollowthroughinthecurrentyear. Theannualizedrateofgrowthfellfrom3.1percentforthefourthquarteroflast yeartojust1.9percentforthefirstquarterof2011.Privateestimatesofmonthly GDPbyMacroeconomicAdvisersindicatethatthelevelofGDPactuallyfellbetween Decemberof2010andJanuaryof2011,andthenfellfurtherinFebruary.Marchwas theonlypositivemonthinthefirstquarter.ThedataforApril,MayandJuneshowed renewedweaknesswitharisingunemploymentrate,asharpfallinemployment gains,lowerrealweeklyearnings,reducedrealretailsalesandindustrial production,declinesinbusinessandconsumerconfidence,acontinuedcollapseof housingpricesandthefirstdeclineintheindexofleadingindicatorssinceearly 2009,beforetheupturnbegan.MonthlyestimatesofGDPfellagaininAprilandMay. SowithoutadollardeclinetheoutlookfortheUSeconomyisverynegative.A declineinthevalueofthedollarcanchangethissignificantly.CuttingtheUStrade deficitfromthecurrentlevelofthreepercentofGDPbytwopercentagepointsof GDPwouldprovideaninitialdemandstimulusequaltotwopercentofGDP.This wouldbemorepowerfulthanacomparablesizefiscalstimulusandwouldprovide

thatstimuluswithoutaddingtothenationaldebt.Itwouldalsoprovidemore stimulusthananythingthattheFederalReservemightdoatthecurrenttime. Thereareofcoursealsonegativeeffectsofafallingdollar.Theunambiguously adverseeffectistoreducetherealvalueofanygivenlevelofpersonalincomesby raisingthecosttohouseholdsoftheimportedproductsthattheyconsume.The magnitudeofthiseffectissubstantialbutshouldnotbeexaggerated.Sinceimports areonly16percentofGDP,a20percentfurtherfallinthedollarwouldreducereal incomesbynomorethanaboutthreepercent.Eventhisoverstatestheadverse effectoftheweakerdollaronrealincomessincevariousimportsareeitherpricedin dollars(likeoil)orexperienceadjustmentsintheforeigncurrencypriceasforeign exportersseektooffsettheadverseeffectoftheweakerdollarontheirexports. Theotheradverseeffectofalowerdollaristocreateinflationarypressure.Again, theeffectisrelativelysmall.A10percentannualfallofthedollarwouldraisethe pricelevelandtherateofinflationbylessthantwopercent.Giventhestateofthe labormarket,thiswouldonlyaffectthepricelevelandwouldnotbethebeginning ofapricewagespiral. Inconclusion,therewouldbebothstrongpositiveeffectsofadollardeclineon aggregatedemandbutalsoadverseeffectsonrealincomesandonthepricelevel. Butthedeclineofthedollarduringthenextfewyearsisnotamatterofchoicetobe decidedbyweighingtheadvantagesanddisadvantagesofalowerdollar.Itis somethingthatislikelytohappen.Ifitdoes,wewillseeacontinuingdeclineofthe dollarandwithitagreaterhopeforastrongereconomicrecovery. Cambridge,Mass. July2011