Conventional Wisdom
The declining value of the dollar is the result of government mismanagement. It's more evidence of America's decline.
Facts
The dollar is, in fact, weak against the Euro and some major currencies. This is helping the U.S. increase exports, which added 1% to the U.S. GDP in 2007 over 2006. However, the dollar is still strong against the Asian countries which export significant amounts of goods to the U.S. and other countries.
To keep the dollar expensive and their own currencies weak, these exporting countries have bought over $4 trillion of U.S. dollars in recent years. This purchase of dollars keeps their products cheap, and thus their exports strong. But such large dollar purchases represent huge sums for these countries, both on an absolute basis and relative to the size of their economies. The resulting enormous dollar holdings represent a significant risk for them; if the dollar continues to decline to what the IMF considers to be a fair value against their currencies, the cost to them would be high.
The dollar is so expensive against the Asian currencies by the IMF Purchasing Power Parity (PPP) measure that, despite the dollar being weak against Europe, the dollar still remains strong against the world, on average. The IMF 2008 "World Economic Outlook," published in April 2008 says, "The analysis of the Consultative Group on Exchange Rate Issues (CGER) of the IMF suggests that the U.S. dollar has now moved closer to its medium-term equilibrium level but still remains somewhat on the strong side."
The dollar has weakened dramatically since 2001. This is mostly the result of an overvaluation in 2001 when the dollar was expensive on every measure against most currencies. An in depth analysis of the IMF Purchasing Power Parity (PPP) demonstrated the dollar's overvaluation in 2000;23 it has gone from a 15% overvaluation against European countries like Germany in 2000 to a 15% undervaluation in early 2008. The dollar is down 30% since 2000, but from an expensive starting point. When the dollar was overly expensive, it contributed to the growth of the U.S. trade deficit by making U.S. exports expensive everywhere in the world and by encouraging U.S. businesses such as Wal-Mart to buy foreign products that looked amazingly cheap compared with comparable products in the U.S.
The broadest perspective indicates that the dollar has merely returned to the level it held in 1994-95, before the massive rise in the dollar and resulting increase in the U.S. trade deficit. The dollar has even adjusted downward by a small amount against Asian currencies in recent years, though not enough. A bigger decline against Asian currencies would help U.S. businesses increase exports to Asia. As measured by the IMF's PPP, the dollar is still overvalued versus India at 170% of the PPP price today, but that's down from a 2000 overvaluation of 217%.
According to the IMF's calculation of how much goods and services a currency can purchase, an overvaluation of 217% means that a dollar in 2000 could buy more than twice the value of goods internationally as the equivalent amount of the Indian currency at the then prevailing rate of exchange. On a trade weighted basis, we are back to the 1994-95 level of the dollar. This can be seen on the chart of the Trade Weighted Dollar below, which evaluates the dollar against currencies, weighed according to each country's flow of trade with the U.S.24
Trade activity often responds to changes in exchange rates with a lag of many years. Changing trading partners can start with a long selling process, then it takes time to set up new contractual relationships followed by the work of increasing production to meet demand. Lastly, end user demand can take years to develop and grow. In 1994-95, the U.S. current account deficit was 1.5% of GDP. As the dollar appreciated 40% over the next seven years, the current account deficit expanded to 4% of GDP. We are now seeing the inverse trends.
At this moment, trade is shifting back to favor U.S. products. In 2005 the Ex-Oil (excluding oil) Trade Deficit started to decline after increasing for years. It is responding to the weakening dollar. The weaker dollar adds to U.S. GDP growth by encouraging U.S. importers to substitute U.S. made products for foreign merchandise, and it encourages foreign companies to buy U.S. goods instead of buying products from outside the U.S. This is extremely good for U.S. GDP growth and jobs. The risk is that a weaker dollar can create inflation.
Assessment
A weak, or inexpensive, currency isn't necessarily bad. If it were, why would the Asian countries be buying trillions of U.S. dollars to keep their own currencies weak? While the dollar has dropped considerably from 2001, its extremely overvalued level at that time was unsustainable and contributed directly to the increase in the U.S. trade deficit.
The recent weakening of the dollar has just returned it to the average exchange rates of the early 1990's. This makes U.S. merchandise less costly in world markets, which leads to increased exports. The last time exchange rates were at current levels, the result was a reduction of the U.S. trade deficit to only 1.5% of GDP. It is likely a return of the dollar to this more sustainable level will, as it did before, continue to lower the trade deficit and help keep U.S. GDP growth strong. The dollar is definitely not at an extreme level of weakness. There certainly is no dollar crisis. The U.S. dollar has simply returned to a sustainable level, closer to its long-term fair value, according to the IMF.
Weak Currencies and Inflation
Reality Check explains how a weak currency and inflation work together and under what no idle plants to produce more goods, a weak currency will provide companies the opportunity to raise prices. A weaker currency at home makes domestic goods and assets appear cheap to circumstances a weak currency can cause problems. The book shows what the effect would be on other countries if the dollar declined further against the currencies of major trading partners. Reality Check also makes predictions about the U.S. balance of trade, inflation, and the relative strength of the dollar, as well as explaining why foreign governments intervene in currency markets to control the value of their currencies relative to the U.S. dollar, and the costs/risks associated with doing so. An analysis is offered of serious ripple effect problems that this intervention caused in many asian countries in the 1990's.
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