Thursday, July 06, 2006

How the Budget Deficit Props Up the Dollar

In an earlier post about the deficit and the dollar, I admitted to “glossing over a lot of details.” I’ll never get all the details into one post, but here are a few more.

What would happen if Congress were to reduce the deficit, let’s say by canceling a bunch of bridges to nowhere? If I were in a hurry, I would say, “The government will borrow less, easing demand on credit markets and causing interest rates to fall.” But that statement is misleading. Short-term interest rates are determined by Fed policy, and long-term interest rates are determined largely by anticipation of future Fed policy. The deficit affects interest rates because it affects Fed policy. So what would really happen? First, many of the people who were supposed to build those bridges to nowhere would lose their jobs, or would not be hired in the first place. The Fed, being a forward-looking institution, would attempt offset the decline in employment by stimulating new employment, which it would do by cutting interest rates.

What happens when US interest rates go down? Among other things, the dollar becomes a less attractive currency, because it offers less interest. Consequently, investors try to exchange their dollars for other currencies. These attempts to exchange dollars present different problems for different countries, depending on whether their currencies are pegged to the dollar.

Consider first a pegged country, China. China will have three options, none of which it will be very happy with. First, it can cut its own interest rates so as to reduce the incentive to hold yuan and stem the tide of dollar exchanges. The problem with this option is that it would further encourage Chinese investment, which by most accounts is already too high, and it would run the risk of causing the Chinese economy to overheat and generate inflation. Second, it can simply accommodate the demand for yuan by increasing its own holding of dollars. The problem with this option is that the People’s Bank of China already has more dollars than it could possibly want. At some point it’s going to start worrying about the risk it takes by holding ever increasing numbers of dollars. The final option is to revalue the yuan. It’s probably not as likely as the other options, but if we want to put pressure on China to revalue, cutting the budget deficit is a good way to do it.

Now consider an unpegged country – well, not a country but a union – the EU. Since the EU doesn’t normally intervene in the foreign exchange market, it will initially allow the market to handle the dollar exodus by letting the value of the dollar drop against the euro. The drop in the dollar will decrease demand for European products relative to US products, and the ECB will attempt to offset this decrease in demand by cutting interest rates. But how far will it go? Will it go all the way and cut interest rates to the point where the dollar rises back to its initial level? Consider what would happen if it did. Europe’s trade balance would be the same as before, but its interest rate would be lower. Since the lower interest rate stimulates demand domestically, the overall level of demand would be higher, and the ECB would worry about inflation. Consequently, it will not allow this situation to occur. It will cut interest rates somewhat, but not enough to fully offset the effect of the US deficit cut on the exchange rate. Thus, in the end, because the budget deficit declined, the dollar falls against the euro.

Notice that any US “weak dollar policy” or “strong dollar policy” has no effect on these outcomes (unless such a policy means that the Fed is willing to override its employment and inflation objectives). In principle, it can’t. If the US as a nation is going to borrow less, then it must run a smaller trade deficit, and the only way to do so (aside from having a recession) is to drop the value of the dollar to make US goods and services more attractive. If the government reduces its borrowing, unless this decline is offset by an increase in private borrowing (or unless the Fed allows a recession to happen), the dollar must fall, regardless of whether the US has a “strong dollar policy.”

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