Beat the Press

Dean Baker's commentary on economic reporting


The Times Versus Bush on the Deficit and the Dollar

The lead editorial in Saturday’s New York Times noted the recent drop in the dollar. It then blamed President Bush’s deficits and warned of an impending recession unless the budget deficit is reduced. As best I can tell, the editorial was incoherent, like much of the discussion on the trade deficit and the budget deficit.

In the last quarter century, the conventional wisdom on the relationship between the dollar and the budget deficit has changed almost as frequently as the seasons. It may not be surprising that politicians would change their views on how the economy works whenever it is convenient. It is a bit more disappointing that the media would show similar flexibility.

In the old days, economists used to say that large budget deficits lead to higher interest rates in the United States. When interest rates in the United States rise, more people want to hold dollar denominated assets (e.g. government bonds or money market accounts in U.S. banks). This increases the demand for dollars, causing the dollar to rise. A higher dollar makes imports cheaper for people in the United States, leading us to buy more imports. It also makes U.S. exports more expensive for people living in other countries, thereby reducing demand for exports. With imports up and exports down, the trade deficit rises.

In this way, a budget deficit could be argued to cause a trade deficit. Note the importance of the dollar in this story -- the high dollar is the key mechanism. People shopping at Wal-Mart don’t buy the imported shirt rather than U.S. made shirt because the U.S. has a large budget deficit; they make the decision to buy the imported shirt because the high dollar has made the imported shirt cheaper.

This part of the story is important to emphasize, because in the Clinton-Rubin era the conventional wisdom was that a high dollar was somehow good, even though it led to an enormous trade deficit. Right thinking people everywhere (many of whom had decried the budget deficits of the Reagan-Bush 1 era in large part because of the trade deficits they caused) espoused the virtues of Robert Rubin’s high dollar policy. In other words, the demon of the over-valued dollar, and the resulting trade deficit, was somehow good when the over-valuation was driven by foreign investors who were anxious to lose their shirts in the U.S. stock bubble of the late nineties.

Now, the high dollar is again bad, although the current cause of the over-valuation is not quite clear in the conventional wisdom (at least as rendered on the Times editorial page). If we assume that the Times has returned to the world of standard economic theory, then the over-valuation of the dollar is attributable to the upward pressure on interest rates that is caused by budget deficits. In this world, a larger budget deficit leads to a higher dollar.

But wait, the Times seems to have a somewhat different story:

“The problem is this: unless a falling dollar is paired with reductions in the federal budget deficit, it could do more harm than good by driving up interest rates, perhaps sharply. That's because the foreign investors who finance the administration's "borrow as you go" budget are likely to demand higher returns to invest in a depreciating dollar.

But if budget deficits declined over the long run, the government's reduced need to borrow would help keep interest rates low as the dollar depreciated.”

Okay, foreign investors will demand higher returns to invest in a depreciating dollar (i.e. if the dollar is falling 5 percent a year against the euro, then investors want a return in dollars that is at least 5 percentage points higher than the return available in euros), that seems right. But, the dollar falls more in a world where the budget deficit is reduced than in a world where it stays high. (Remember – a higher budget deficit leads to a high dollar.)

This means that, at least through a period of transition to an era of a lower dollar, we might expect higher interest rates if the budget deficit were to be reduced rapidly and then the dollar fell enough to fill the gap in demand with more net exports.

I apologize if this discussion is unnecessarily complex, but tackling warped logic is not always easy. Putting a different twist on the basic issue could be helpful.

An over-valued dollar, regardless of the cause, creates imbalances (i.e. trade deficits) that inevitably imply a painful correction process. The current over-valuation was not caused by budget deficits (remember, we had a huge budget surplus in 2000, when the dollar was considerably higher than it is now). The correction from the over-valued dollar is going to hurt regardless of what we do with the budget deficit. The price of imports will rise between 10-20 percent, raising the rate of inflation and reducing living standards in the United States.

There are good arguments for reducing the budget deficit, but it’s just silly to pretend that the pain from a falling dollar is attributable to the budget deficit, or that a lower deficit will somehow prevent this pain.


  • At 5:27 PM, Blogger spencerengland said…

    You have been doing a great job here and I love your blog. but this is one area where I have to disagree with you.

    Under Reagan and Bush the current account defict represented borrowing to finance consumption.
    But under Rubin the borrowing was to finance an investment boom --
    in the 1990s almost 50% of the capital spending boom was financed by the combination of the federal surplus and foreign capital inflow.
    So the borrowing was used to create productive capacity to repay the loan. But under bush we have gone back to borrowing abroad to finance consumption and the borrowing is not being used to create the capacity to repay the loans.

    It is like taking out a home equity loan to finance a vacation in Disneyworld versus taking out the loan to start a business.

  • At 7:09 PM, Anonymous James Schipper said…

    Dear mr Baker
    My understanding is that exports + borrowings = imports + lendings. This is an oversimplification of course because there is also investment income, cash holdings, sale or purchase of assets. Nonetheless, a country that is a net borrower, as is the case with the US, has to run a trade deficit.
    What makes a country a net borrower depends a lot on the domestic savings rate. Savings + net borrowings from foreigners = budget deficits + investments. In the US, the savings rate is very low and budget deficits are very large, so there have to be net borrowings. If there are net borrowings, there has to be a trade deficit.
    As long as the American savings rate remains low and as long as long as foreigners are willing to lend, the trade deficit will continue. It can't continue indefinitely of course because eventually the American foreign debt will so big that servicing that debt will dwarf the borrowings from abroad.
    An exchange rate is a price, and a price is good depending on whether you are a seller or buyer. For sellers, a high price is good and for buyers a low price is good. What matters really is whether the exchange rate is right in terms of creating a balance betwen inflows and outflows.
    Regards. James

  • At 12:25 PM, Blogger knzn said…

    You seem to be ignoring the distinction between anticipated and unanticipated exchange rate movements. True, an anticipated decline in the dollar would have to be associated with higher US interest rates. But if Congress unexpectedly cuts the deficit, the resulting decline in the dollar will not be anticipated. Therefore it need not be associated with higher US interest rates. It might be associated with lower US interest rates – just as the Times suggests – if dollar assets and non-dollar assets are imperfect substitutes.

  • At 10:42 AM, Anonymous Joe Populist said…

    The role of the National Bank---which is what the FED is---has been a subject of political struggle between producers (workers) and speculators (Wall Street) since the beginning of the republic.

    Debates over monetary policy are not at the center of most political discussion today, although they should be. And I'm glad you and other economists are finally discussing it.

    ON the other hand, monetary economics is very difficult to explain to the average person. A lot of so-called "free marketeers" on the Republican side of the street have very simplistic views of how the 'free market' works.

    I'm wondering if a reason for the voter apathy and low voter turnout might be explained by the fact that most working folks realize that most of the decisions that affect the trade balances, the cost of imports, the relative value of their wages, as well as their chances of scoring a decent job are out of the hands of our elected representatives. Instead, like Soviet Communism, these decisions are being made behind closed doors by unelected bureacrats at the FED, the WTO, and the World Bank

  • At 1:43 PM, Anonymous ray benish said…

    enjoyed your writing on relationship between domestic deficit and trade deficit. But I thought as trade deficit worsened and became sustained, eventually the dollar would decline in value as surplus of dollars arose thus making imports more expensive and exports more competitive. But exactly what would we export besides weapons and boeing jet liners? And as we no longer have domestic production of consumer goods, we have no choice but to continue to import even in face of higher cost. An 805 $B current account deficit in 2005, is this a good deal? seems like most will be debt that will have to be repaid.

  • At 3:36 AM, Anonymous Anders said…

    Perhaps the foreign investors are (as ever in the world of the dollar reserve currency) simply in no position to demand higher returns on their investment for all the usual historical reasons (oil transactions being denominated only in dollars, lack of military power behind the bargaining power)

  • At 7:27 AM, Anonymous Anonymous said…

    Correct me if I am wrong, but it seems the last time we had a war as well as excess government spending was in the 60's when Johnson wanted the Great Society as well as Vietnam. Seems we had a recession in the70's as a result.

  • At 5:38 AM, Blogger Dean Baker said…

    A couple of quick points:

    In my assumptions about the behavior of financial markets I am simply following the Times. It was the Times that said that a falling dollar would lead to higher interest rates. If this is true, then the dollar should fall more if we get the deficit down, and by the Times logic (not mine), this means higher interest rates.

    On the question of borrowing for investment verse consumption, the investment share of GDP was just 1.1 percentage point higher in the years 1998-2000 (the peak of the 90s boom) compared with the years 1987-89 (the peak of the 80s boom). Investment was well below its 70s share.

    Roughly half of the increase in investment in the 90s compared with the 80s was offset by a higher trade deficit. (In 2000, it was more than offset.)

    Furthermore, much of the growth in investment was simply due to accounting. There was a huge surge in car leasing in the 90s. A leased car is counted as investment by the leasing company. A purchased car is counted as consumption. This shift explains more than half of the increase in investment in the 90s compared with the 80s.

    I discuss this comparison in a paper last fall, although the car leasing point does not appear in this version.

  • At 10:19 AM, Blogger knzn said…

    The Times is implicitly making the distinction between anticipated and unanticipated depreciation. A depreciation that happens in the absence of new information would presumably be anticipated and therefore associated with higher interest rates to compensate for currency losses. A depreciation that happens in response to news about the deficit would be unanticipated and therefore not associated with higher interest rates.

    I grant you, the Times has got the logic backwards when it attributes the expected higher interest rates to investors’ response to a falling dollar. Of course, as far as investors are concerned, it is interest rates (set by the Fed and by the market in anticipation of future Fed policy) that determine exchange rate movements and not the other way around. But once we include the Fed in the picture, the causation reverses: a falling dollar causes increased demand for US products, which raises overheating concerns, prompting the Fed to raise rates. But if the falling dollar is caused by a declining deficit, then the increased demand in the foreign sector will be more than outweighed by decreased demand from the government and/or taxpayers (depending on how the deficit is cut), so the Fed will not raise rates.

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