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Strong Dollar might be Counterproductive to Economic Growth

By       Message Seymour Patterson     Permalink
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In a previous post, I talked about the relationship between deficits and growth--or to put it slightly differently--austerity (surplus seeking) versus stimulus (government spending). On either side of the economic or political divide advocates argue that growth will follow from austerity or growth will follow from stimulus. It is not impossible that both these outcomes could be possible under the right set circumstances, although the evidence that a debt-to-GDP ratio in excess of 90 percent is counter-growth does not hold up.  Further, reducing the deficit will not magically spur economic growth--not via channels of confidence (CEOs' assumption of government fiscal responsibility); and not through raising saving (from deficit reduction) that increases the supply of loanable funds and lowers interest rates. A very cursory look at the Federal Reserve Bank's loose money policy that has kept interest rates low by historical standards indicates that this link is not viable: low interest rates don't stimulate economic growth, at least not now. Current low interest rates lend the lie to that argument. But low interest rates do weaken the dollar against major foreign exchange. The idea of a weak dollar alarms some people for any number of reasons--one possible reason is national pride (people see a weak dollar as evidence of U.S. decline). And a weakened dollar should make U.S. exports a tad more competitive on the world market. Exports should increase because U.S. goods valued in terms of U.S. dollars will be cheaper relative to some foreign currencies. But this is not happening. In May 2013 the U.S. international trade deficit rose 12.1 percent from April 2013--that's because exports fell 0.3 percent and imports rose 1.9 percent. (See Economic Indicators)

Like a reduction in the government deficit, a rise in the trade deficit implies a fall in aggregate demand. In a weak economic environment such as we are faced with now, we don't want weak demand. That only makes matters worse contrary to the pronouncements of austerity hawks. It seems that interest rates continue to suffer from what Keynesians call the liquidity trap--which makes the Fed's easy money agenda impotent. But businesses are awash with cash--the Dow hovers over 15,000, corporate profits have risen exponentially, and bailed out banks like Wells Fargo, Bank of American and JPMorgan Chase have recovered and earning record profits--but Main Street suffers 7.4 percent unemployment and low wages.  As a sidebar, we bailed out the auto industry, and banks/investment companies, but we seem to want to encourage Detroit to file for bankruptcy, putting pension funds at risk. And Speaker Boehner threatens another debt-ceiling battle--he will not raise the debt ceiling without concessions from President Obama on spending, most likely in the form of cuts to social programs like Social Security and Medicare that benefit retirees. We have seen the script before. In the House of Representative, there's a proclivity to repetitive behavior like voting to repeal the Affordable Care Act a.k.a Obamacare 40 times and counting. But I digress.

Back to the core topic of this piece--i.e. growing aggregate demand and the strength of the U.S. dollar. The argument for a strong dollar has strong appeal but it might not be good for the U.S. economic recovery. There are at least two reasons why. First, let me layout the argument based on national saving and loanable funds; and second, the relationship between national saving and demand. National saving can be decomposed into three parts--private saving, government saving, and foreign saving. Private saving is just the difference between your income minus taxes minus consumption; government saving is government tax receipts less government spending, and foreign saving is imports less exports. When the government runs deficits aggregate demand for goods and services increases. However, a trade deficit, that is, imports in excess of exports reduces aggregate demand. Thus, when there is a stock market bubble (as in the 1990s) and the recent housing bubble, both of these events caused the country's aggregate demand to rise.

Okay, now suppose interest rates were to go up. One way this could happen is if the government deficit increases. The higher interest rates would likely increase the demand for U.S. government bonds, driving the value of the dollar up. The higher value of the dollar in turn will encourage more imports of foreign goods in the U.S. This will reduce aggregate demand. But the narrative does end there. Higher interest rates will discourage firms from investing, further reducing aggregate demand in the economy. One would have to hope that the boost in aggregate demand due to increased government spending more than offsets the dual reductions in aggregate demand from crowding our of private investment and from the increase in imports. The Keynesian narrative assumes this to be the case.

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But suppose the government were to cut taxes--running deficits, but not from additional spending--this should induce more saving by households. Then an increase in private saving will also increase national saving, and ultimately the supply of loanable funds. The reduction in interest rates here is expected to expand private investment, thereby growing the economy. The dollar weakens in this scenario and U.S. exports increase. The current status quo, however, is the weak dollar scenario due to Fed policy for economic growth in a slow growth environment. But this might not be entirely bad--depending on one's goal. That's because higher interest rates would benefit senior citizens holding U.S. Government (and corporate) bonds. Higher rates would generate interest income to supplement their retirement and Social Security benefits. However, there are other issues with this policy of low interest rates: (1) it has not helped economic growth--private investment has not mushroomed, and (2) the country is running a trade deficit to boot. So, the Fed's policy to date has been counterproductive--it certainly has not lived up to expectations. Further, theoretically a weak dollar should have raised demand through greater exports of U.S. goods. But this is offset by efforts to reduce the government deficit--a position vehemently followed by Congress to counter stimulus spending for growth by the Obama administration. I would contend that a dollar spent by the government is a dollar spent. But a dollar increase in income from a consumer tax cut causes some fraction of this dollar to bleed away into saving, which is not stimulative because it reduces aggregate demand.

Private consumption of goods and services is a whopping 71.0 percent of GDP. It is not surprising then that when private consumption suffers in a recessionary environment because of reductions in income from job losses the economy feels the pain. The business sector is not a trivial part of the economy at 13.4 percent of aggregate demand. And in a bad economy businesses face a quandary here--a lack of investment incentive and opportunities because of low demand for their goods and services. Business inventories rise because they can't sell their goods to consumers who are jobless in a recession. This can happen when a booming housing market or the stock market collapses. But government spending is 18.9 percent of GDP--so this sector has to do a lot of heavy lifting while trying to navigate the economy back to full employment. (See Global Economic Analysis) Although the trade sector can assist, it is small--the current account balance  (i.e. exports less imports) as a percent of GDP is about -3.4 percent. (Data source: Bureau of Economic Statistics, July 2013 "GDP and the Economy") Clearly, aside from consumers the sector with the muscle to affect the economy is the government sector.

President Obama appears prepared to redouble his efforts to get the economy moving, albeit more rapidly. While he could brag about the 135,000 additions to the employment statistics per month (he inherited an economy losing about 600,000 jobs a month between June 2008 and December 2008) during his tenure, he cannot take a victory lap around the economy yet. There needs to be more job creation whether by incentivizing the private sector or through direct stimulus spending. The official unemployment rate of 7.4 percent is not satisfactory. There is not real excuse for the slow pace of the economic recovery. In fact, it is the responsibility of the president to find a way to move the economy to a place of full employment--with or without any help from a do-nothing Congress with the abysmal approval rating of 12 percent. Perversely, some members of Congress might be proud of the poor showing, never mind that their actions might have led to the most anemic economic recovery in memory. Speaker Boehner boasts, "Judge Congress by how many laws it repeals, not passes." This from a lawmaker! There is a surfeit of ambiguity in this Congress that borders on malfeasance: proposed cuts in SNAP (Supplemental Nutrition Assistance Program), threats of government shutdown, sequester, votes to repeal Obamacare, and on and on. Let me repeat, perhaps, ad nauseum that the economic recovery might have already been a done deal but for the intractability of the party in control of the House of Representatives and a Senate not shy to use the filibuster to thwart the president at every turn. Yet, for the good of all of us, the president needs to find a way to overcome Congressional obstruction going forward.

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)
 

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