Additional thoughts about exchange rates

During the late 1990’s, I started paying close attention to exchange rates. The steady increase in the value of the U.S. dollar that started in 1996 is an important cause of our low wheat prices between 1998 and 2001. See the articles in the Exchange Rates section.

Since peaking in 2002, the value of the U.S. dollar relative to a trade-weighted average of all other currencies (as measured by the Federal Reserve Board’s Broad Inflation-Adjusted Index) has declined by about 10%. The decline has been much more relative to currencies that trade freely and less relative to the currencies of the oil exporting countries and the countries (mainly in Asia) that buy dollars to keep their currencies undervalued and their exports cheap. China now has over $1 trillion stashed away in its currency reserves and has allowed the inflation-adjusted value of the Yuan to appreciate by only 8.5% since 2002 (as its trade surplus increased to over 10% of its GDP).

U.S. wheat growers have been lucky. The currencies of our competitors trade freely without government intervention. Since 2002, the U.S. dollar has declined by 40% relative to the Australian dollar, 34% relative to the Canadian dollar, 42% relative to the Euro, and 26% relative to the Argentine Peso. According to the USDA exchange rate website, between 2002 and April of 2008 the value of the U.S. dollar declined by 34% relative to a weighted average of our competitors’ currencies and by 20% relative to a weighted average of our customers’ currencies. This falling value of the U.S. dollar is one of the important reasons for the recent rise in wheat prices.

Problems for the U.S. economy

The falling dollar has stimulated U.S. exports and caused the U.S. overall trade deficit to start declining — from 6% of GDP in 2006 to 5.3% of GDP in 2007. However, the excess of imports over U.S. exports is still more than $700 billion. With rising oil prices, a 10% decline in the value of the U.S. dollar has not been enough to make much of a dent in the trade deficit. The U.S. imports over $3 trillion of goods each year from other countries. To purchase these imports and all the goods produced by U.S. economy for our domestic market, the combined deficits of the U.S. household, business and the government sectors were 5.3% of GDP in 2007. A trade deficit requires total spending in the U.S. economy to be greater than U.S. income.

Until recently, rising housing prices made deficit spending attractive for U.S. households. Mortgage lenders were aggressively soliciting new business and more than willing to refinance existing mortgages so homeowners could spend their rising home equity. In 2007, U.S. households saved only $43 billion and borrowed $361 billion for new housing — so the overall deficit of the household sector was $318 billion or 2.3% of GDP (down from $460 billion or 3.5% of GDP in 2006) . Business investment was almost exactly equal to retained profits in 2007, so the business sector had no deficit. The government deficit in 2007 was $412.3 billion or 3% of GDP.

With housing investment collapsing and households no longer able to spend the rising equity in their homes, U.S. households will be forced to reduce borrowing. I’ve often read that “one of the best ways to lose money is to bet against the ability of U.S. consumers to increase spending.” However, I don’t know where U.S. consumers will find financing for additional spending. With economic conditions weakening, businesses are also unlikely to increase spending. If consumer spending slows, government borrowing will need to increase to offset the huge drag on our economy from the trade deficit. Unfortunately, much of the required growth in the federal deficit may come from the recently passed Wall Street rescue bill. For an interesting discussion of these issues by a great economist, read Martin Feldstein’s article.

A final point

As discussed above, the U.S. trade deficit is stuck above 5% of GDP largely because of rising oil prices and because developing countries are intervening (buying dollars) to prevent their currencies from appreciating in value relative to the U.S. dollar. These countries are following the classic beggar-thy-neighbor policy of using currency manipulation to expand their exports. China is by far the most important example. China’s actions are clearly in violation of the International Monetary Fund’s (IMF) rule against “protracted large-scale intervention in one direction in the exchange market.”

The IMF was established to police the international financial system and exchange rates in particular. Recently, it has done almost nothing to enforce its own rules. This seems to be a source of some embarrassment at the IMF. I think two reasons account for the IMF’s inaction. First, when the countries in emerging Asia started using currency intervention as a development strategy several decades ago, they were a small share of world trade and could be ignored. Recently, China passed the U.S. to become the world’s second largest exporter and is challenging Germany for the top position. China can no longer be ignored or be given a “free pass” as a small developing country. However, forcing China to play by the rules of other large economies has a big downside. Evidence has been accumulating that an undervalued exchange rate is a key part of a successful development strategy. I don’t know of a good non-technical summary of this evidence, but you might check out this article.

China has been wonderfully successful in moving 400 million people out of extreme poverty. Does the IMF (or any of us for that matter) want to take responsibility for forcing changes in a strategy that has achieved so much?

Second, the IMF has lost its ability to force countries to follow its rules. Until the last decade, all currency crises involved countries trying to maintain overvalued exchange rates. An overvalued exchange rate causes trade deficits and a loss of currency reserves. An example is the Asian financial crisis in 1996-7. Then, countries were forced to go to the IMF for help and to make the changes required by the IMF as a condition for receiving its assistance. The current situation is exactly the opposite. Countries are maintaining undervalued currencies with trade surpluses and growing currency reserves. Asian governments have more reserves than the IMF! They can easily ignore the IMF. It is striking that in just a decade the IMF has gone from the feared policeman of the world to irrelevance.

The current financial crisis and economic slowdown are spreading rapidly around the world. During the last financial crisis in 1996-7, the world turned to the U.S. and the IMF for leadership and resources. Both the U.S. and the IMF are in much weaker positions today. Where will the leadership come from to resolve the current crisis? For a pessimistic view of the IMF’s current role, see Barry Eichengreen’s article.