The lead editorial in Saturday's New York Times noted the recent drop in the dollar. It then blamed President Bush's deficits and warned of an impending recession unless the budget deficit is reduced. As best I can tell, the editorial was incoherent, like much of the discussion on the trade deficit and the budget deficit. In the last quarter century, the conventional wisdom on the relationship between the dollar and the budget deficit has changed almost as frequently as the seasons. It may not be surprising that politicians would change their views on how the economy works whenever it is convenient. It is a bit more disappointing that the media would show similar flexibility. In the old days, economists used to say that large budget deficits lead to higher interest rates in the United States. When interest rates in the United States rise, more people want to hold dollar denominated assets (e.g. government bonds or money market accounts in U.S. banks). This increases the demand for dollars, causing the dollar to rise. A higher dollar makes imports cheaper for people in the United States, leading us to buy more imports. It also makes U.S. exports more expensive for people living in other countries, thereby reducing demand for exports. With imports up and exports down, the trade deficit rises. In this way, a budget deficit could be argued to cause a trade deficit. Note the importance of the dollar in this story -- the high dollar is the key mechanism. People shopping at Wal-Mart don't buy the imported shirt rather than U.S. made shirt because the U.S. has a large budget deficit; they make the decision to buy the imported shirt because the high dollar has made the imported shirt cheaper. This part of the story is important to emphasize, because in the Clinton-Rubin era the conventional wisdom was that a high dollar was somehow good, even though it led to an enormous trade deficit. Right thinking people everywhere (many of whom had decried the budget deficits of the Reagan-Bush 1 era in large part because of the trade deficits they caused) espoused the virtues of Robert Rubin's high dollar policy. In other words, the demon of the over-valued dollar, and the resulting trade deficit, was somehow good when the over-valuation was driven by foreign investors who were anxious to lose their shirts in the U.S. stock bubble of the late nineties. Now, the high dollar is again bad, although the current cause of the over-valuation is not quite clear in the conventional wisdom (at least as rendered on the Times editorial page). If we assume that the Times has returned to the world of standard economic theory, then the over-valuation of the dollar is attributable to the upward pressure on interest rates that is caused by budget deficits. In this world, a larger budget deficit leads to a higher dollar. But wait, the Times seems to have a somewhat different story: "The problem is this: unless a falling dollar is paired with reductions in the federal budget deficit, it could do more harm than good by driving up interest rates, perhaps sharply. That's because the foreign investors who finance the administration's "borrow as you go" budget are likely to demand higher returns to invest in a depreciating dollar. But if budget deficits declined over the long run, the government's reduced need to borrow would help keep interest rates low as the dollar depreciated." Okay, foreign investors will demand higher returns to invest in a depreciating dollar (i.e. if the dollar is falling 5 percent a year against the euro, then investors want a return in dollars that is at least 5 percentage points higher than the return available in euros), that seems right. But, the dollar falls more in a world where the budget deficit is reduced than in a world where it stays high. (Remember, a higher budget deficit leads to a high dollar.) This means that, at least through a period of transition to an era of a lower dollar, we might expect higher interest rates if the budget deficit were to be reduced rapidly and then the dollar fell enough to fill the gap in demand with more net exports. I apologize if this discussion is unnecessarily complex, but tackling warped logic is not always easy. Putting a different twist on the basic issue could be helpful. An over-valued dollar, regardless of the cause, creates imbalances (i.e. trade deficits) that inevitably imply a painful correction process. The current over-valuation was not caused by budget deficits (remember, we had a huge budget surplus in 2000, when the dollar was considerably higher than it is now). The correction from the over-valued dollar is going to hurt regardless of what we do with the budget deficit. The price of imports will rise between 10-20 percent, raising the rate of inflation and reducing living standards in the United States. There are good arguments for reducing the budget deficit, but it's just silly to pretend that the pain from a falling dollar is attributable to the budget deficit, or that a lower deficit will somehow prevent this pain.
--Dean Baker
