The myth of the strong dollar

David Glasner did a post heavily critical of arguments put forth in a WSJ commentary by David Malpass, former undersecretary of the Treasury under Reagan and former Chief-Economist of Bear Sterns.

Krugman picked up on it and “generalized”:

But what’s really interesting, as Glasner notes, is the incoherence. And this is an issue that goes beyond the woeful Malpass; it pervades the WSJ in general, and is broadly visible in much conservative economic writing, including the academic side.

And concludes:

The point is that at this point we’re not having a debate between opposing models; we’re having a conflict in which one side has a model that has been working, while the other side has prejudices, and makes stuff up to justify those prejudices.

A very “postmodern” argument and pretty heavy stuff considering you have Nobel Prize winners on both sides of the “ideological divide”. Krugman even creates an “axis” which he calls the “Krugman/Thoma/DeLong axis”.

That kind of “debate” is fun to watch from the sideline, even if it´s quite unproductive.

I take the opportunity, given the title of Malpass piece, “Weak dollar, weak economy”, to try and debunk the “strong dollar” myth, a “concept” that over the last 30 has been used to call presidents to “task”.

There is certainly one country that has “pursued” a strong exchange rate policy. That´s Japan. Figure 1 shows the almost continuous “strengthening” of the yen against the dollar.  Given the debilitating state of the Japanese economy over the last 20 years, that should cause some “concern” for those who associate a “strong” currency with a “strong” economy.

And it´s ironic that the permanent state of “strength” of the yen is a consequence of the many US “threats” over the years since the late 1970s against Japan lest it let its currency depreciate.

Why else do we observe that between 1980 and early 1985 the dollar appreciated strongly against all currencies, except, you guess, against the yen. And between 1985 and late 1987, when the dollar sank against all currencies, it also sank against the yen. The figure below shows describes the “dollar ride” during the period using both the DM/USD and Yen/USD exchange rates indexed to 100 in January 1980. While the DM depreciated by more than 80% until early 1985 and over the next three years returned to its initial level, the yen appreciated on net more than 40%.  I´m not going into the details but be aware that this fact was instrumental in generating the policies that were ultimately responsible for the Japanese stock market bubble and subsequent market and economic crash that lasts to this day.

With regards to the “strong” dollar myth, note that the US economic growth picked up strongly following the 1981/82 recession while the dollar was “strengthening” and continued to grow robustly while the dollar was “weakening”.

But to Malpass:

Washington’s twin crises—fiscal and monetary—are killing jobs. It may take years to fully unwind the federal government’s debt buildup and the entrenched tax-and-spend culture driving it. But the president, or his deputies, could stop the monetary-policy half of the crisis tomorrow, renewing America’s spirit and job growth. The historical evidence is irrefutable—investment floods to strong and stable currencies.

Certainly a false conclusion!

Let´s jump to the mid 1990s. From early 1994 to April 1995 the dollar depreciated against major currencies. The next picture uses the Yen and DM again as examples.

Maybe some of you remember Rubin´s utterances about how the government pursued a “strong” dollar policy (but really didn´t do anything about it). It was fun to follow the reactions. Diane Kunz, at the time a history professor at Yale specializing in the economic and financial aspects of American diplomatic history in the 20^th century wrote an article in the July 95 issue of Foreign Affairs with the title: “The Fall of the Dollar Order: The World the United States is Losing”. There we read:

A sailor embracing his girl in Times Square amid cheering throngs may be the dominant image of America’s victory in World War II. Today Times Square is full again, but this time with foreign tourists, who crowd into New York and other American cities, eagerly hunting bargains with their ever-strengthening currencies. During the first quarter of 1995, the dollar plummeted to record lows against the Japanese yen and German mark. A cheaper dollar has brought tourist income to the United States, setting off a boom in the service sector. Yet at the same time the declining dollar has made American manufactures more competitive against foreign goods, both at home and abroad.

All is well, proclaim Clinton administration officials. Treasury Secretary Robert E. Rubin says that “a strong dollar is in the United States’ national interest” but suggests no steps to realize his incantation. Declaring himself helpless against the foreign exchange market turmoil, President Bill Clinton asserts that “the ability of government to affect currencies in the short run may be limited.” In the end, the administration is indifferent to the slide of the dollar as the premier reserve and trading currency.

American domestic prosperity during the Cold War, as Clinton and Rubin hardly seem to recognize, was based on a triad of factors: American domestic economic policy, American security policy, and American foreign economic policy, in particular the role of the dollar. The synergy among these three elements has brought prosperity at home and security abroad. V-E Day marked the beginning of the dollar era. If the administration does not change its laissez-faire dollar policy and cut the budget deficit, boost savings, and take a hard line on trade, the 50th anniversary of V-E Day will signify its collapse.

If you´re wondering, the collapse didn´t come. The picture shows what transpired over the next several years.

But we already “know” that there can be no lasting depreciation of the yen.

The last figure “proves” the myth of the “strong” dollar. It shows the real trade weighted exchange rate of the major currencies against the dollar. At present, in real terms, the dollar trades at levels that correspond to the minimum over the floating exchange rate history. Anybody cares to take a guess of its future direction? Will it turn up in “typical” cyclical fashion or will it brake through its “historic” floor?