For Richer or Poorer

Robert Reich (hat tip: Mark Thoma) says that the weak dollar is going to make Americans poorer (except for those who are rich enough to hedge against the dollar’s fall) and that “the real worry isn’t inflation” but “our pocketbooks.” Reich’s scenario is indeed what you get from a comparative static exercise in a simple full-employment model: when the terms of trade shift against you, you end up worse off, and (provided nobody expands the money supply) inflation isn’t an issue because falling prices outside the tradable sector (like, let’s say, in housing) offset rising prices for tradables.

But real life is not a comparative static exercise, and everything else doesn’t get put on hold when we go from an old equilibrium to a new one. In the past, the overwhelming tendency has been for the US (as a whole, anyhow) to get richer over time, and I doubt that the terms-of-trade shock, by itself, will be enough to reverse that tendency over the next few years. The US may get a recession, and that may make the US temporarily poorer, but if we are heading for a recession right now, it is in spite of, not because of, the falling dollar. Aside from the possibility of a recession, the US capital stock will continue to grow as usual, technology will continue to improve as usual, and, provided that the terms-of-trade shock is not too precipitous, improving domestic productivity will offset the deteriorating terms of trade.

What if the terms-of-trade shock is too precipitous? Then the US will get poorer, temporarily, but the long-run improvement in productivity will continue, and after a few years, we should catch up again. But a precipitous shock would lead me to question Professor Reich’s assertion that “the real worry isn’t inflation.” A sudden deterioration in the terms of trade would (as I argued in my earlier posts about labor cost targeting) put the Fed in a difficult position. Given the stickiness of many domestic wages and prices, the diminution of living standards that Reich foresees would not happen without a fight, and the result of the fight would be either inflation or recession. I would be more worried about either of those possibilities than I would about the fact that some people will have to make modest reductions in their standards of living.

It’s also not unthinkable that the falling dollar could end up improving US living standards, paradoxical though that may seem. The overvalued dollar has pushed a disproportionate fraction of US resources into the nontradable sector. One has to wonder whether this imbalance has damaged productivity growth. It’s a lot easier to imagine productivity growth happening in tradable industries like manufacturing and Internet-based services than in, say, construction and mortgage finance. Surely real investment will make a much greater contribution to productivity if it goes into plant and equipment for export industries rather than into residential housing. And as one who believes that there is more slack in the US labor market than is generally recognized, I hold out the hope that the stimulus from a weak dollar will help us discover that slack and give the US a Keynesian free lunch to offset the rising cost of the French wine we’ll be drinking with that lunch.

Professor Reich also suggests that the weak dollar will have a regressive effect on distribution, but again I’m skeptical. The tradable sector is where most of the good working class jobs are (or were, and presumably could be again). Reduced foreign competition will also put workers in a better position to negotiate a bigger slice of the pie in industries where there’s room for negotiation. If it becomes relatively more economical to produce in America, that’s no net advantage for the world’s capitalists (who will lose, for example, on European production what they gain on American production), but it will be a big advantage for the American workers who are available to do the producing.

Having said all this, I want to point out that, while the prognosis for the dollar is certainly not good, reports that the dollar is already dead have been greatly exaggerated. Yes, the dollar is at a record low against the Euro, but this doesn’t mean that the dollar has crashed. It just means that the dollar’s general downtrend, which has been in place for five years, is continuing, and that we happen to have been in a declining phase of the variation around the trend. There is a good chance that the dollar will keep going down from here and that the general trend will accelerate. But that’s hardly a foregone conclusion. Anyone who remembers the fall of 2004 should know to be cautious in extrapolating the weak dollar into the immediate future.