An Urban's Rural View

A headline in the July 6 Wall Street Journal posed a question I've been asking since the early 1980s. "The Dollar Will Eventually Pay the Price for U.S. Deficits," the headline began. "In the long run, the dollar should be weaker. But when will the long run arrive?"

(https://www.wsj.com/…)

When, indeed? When I arrived in Tokyo for the first of my two tours as Wall Street Journal bureau chief in August of 1980, the dollar was trading at around 225 yen. A smart Japanese colleague urged me to park my savings in a yen account, as the U.S. was likely to run big trade deficits against Japan in the years ahead. Inevitably the yen would strengthen, giving me more dollars to take home when I repatriated.

I thought he had a point, but at the time I didn't have enough savings to merit opening a yen account. Just as well, for while my colleague was right about the trade deficits he was wrong about the dollar. It was trading at around 235 when I left Japan in December of 1983. Despite year after year of U.S. trade deficits with Japan, the dollar had strengthened slightly against the yen.

This defied economic theory, which says trade deficits tend to self-correct thanks to exchange-rate adjustments. In theory when we buy more from the Japanese than we sell to them our demand for yen increases, which drives up the yen's value. That makes Japanese goods more expensive to Americans, so we buy less of them. At the same time, the stronger yen makes American goods cheaper to Japanese, so they buy more of them. Our exports increase, our imports decrease and trade comes back into balance.

Or at least that's the way it's supposed to work. From 1980 to 1985, it didn't. The dollar rose 50% against the currencies of Japan, Germany, France and Britain even as the U.S. merchandise trade deficit with the world widened from $25.5 billion to $122.2 billion. The dollar only fell after the major trading countries, fearing a protectionist backlash in the U.S., got together at the Plaza Hotel in New York and agreed to coordinated sales of dollars by their central banks.

Why did they need to do this? Why didn't the dollar swoon as U.S. trade deficits ballooned? Because trade isn't the only thing influencing currency values.

First and foremost, foreign investors bolster the dollar. America's large, rich, open economy, propensity to consume rather than save and rule-of-law predictability offer enticing opportunities for profitable foreign investments. In addition, a federal government that has run budget deficits in all but five of the last 60 years creates plenty of debt instruments -- Treasury notes, bills and bonds -- for foreigners who want to make a decent, safe return on their savings.

In the early 1980s, the U.S. offered an extra enticement -- double-digit interest rates, which Paul Volcker's Federal Reserve had inflicted on the country to bring inflation under control. My Japanese colleague was a better economist than an investment advisor. The smartest place for me to have placed my non-existent savings in the early '80s would have been U.S. Treasury paper.

Bottom line: The trade deficit's downward pull on the dollar is usually more than counteracted by the demands of foreign investors for greenbacks.

Then there's the dollar's status as the world's reserve currency. Dollars constitute 64% of the known reserves held by foreign central banks (https://www.thebalance.com/…) and many transactions between parties outside the U.S. are conducted in dollars. The result is a steady demand for American currency. Some 85% of foreign currency trading is in dollars.

For those who produce agricultural products for export, this is not good news. The takeaway is the dollar will almost always be stronger than if its value were determined by trade alone. Even during times of dollar weakness, foreign investment keeps the dollar from sinking as much as it otherwise would.

It's also, incidentally, bad news for people like our president who are obsessed with reversing U.S. trade deficits. There's a reason the country has run trade deficits for 42 consecutive years, and it isn't that American producers are incapable of making saleable products. These deficits won't be easy to turn around. The dollar never weakens quite enough.

The dollar's reserve-currency status has enabled us to live beyond our means. We consume more than we produce; our government spends more than it takes in. Yet the world continues to bank us. It seems like this can't go on forever, but it's gone on for a very long time. When will the long run arrive?

Unfortunately, one likely way for it to arrive is for foreign investors to lose confidence in the U.S. and its government. So dependent is the U.S. on foreign money that the adjustment to foreign disinvestment would be extremely painful. The dollar would weaken -- really weaken, this time -- but interest rates would soar and the economy contract.

Foreign investors haven't lost confidence yet, but if those fiscal and trade deficits continue to widen they someday could. As much as a really weak dollar would boost ag exports, we will all probably be better off if the long run never arrives.

Urban Lehner can be reached at urbanize@gmail.com

(ES)

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