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Tuesday, December 25, 2007

Is a Falling Dollar Good or Bad for the US Economy

Prof Bug has been busy the last two months posting a lot of queries and commentaries at Consumer Reports, more specifically in their car forums. One of the most recent posts has to do with the falling dollar's exchange rate vis-a-vis the Euro, the Canadian dollar, and to an extent the Japanese Yen, with the Chinese Yuan unchanged in its fixed currency rate in dollar terms. The post you're reading, please note, is in a fairly long thread that the buggy prof himself started. (The main reason that brought prof bug to CR's forums, which requires an online subscription, is that I wanted a new, safer SUV to replace a 2005 Jeep Cherokee that was still under factory warranty, ran well, but had major problems with its visibility through the windshield and front seat windows. In the end, I opted for a certified 2006 Acura MDX with only 20,000 miles on, with 2.5 years left on its factory warranty, plus a "free" third year that Acura's certification carries . . . all bumper to bumper. Prof bug will expand on this theme some time soon.)

Here are some links to articles in today's Financial Times that touch on the topics treated in this thread on the outlook for various car companies. To read the articles in total, you have to register (free) at this impressive daily newspaper, whose economic and financial coverage, along with commentaries and blogs, are matchless.

1) BMW --- whose profits (surprisingly) as a percentage of sales are far behind Mercedes' --- is going to cut its workforce by over 12,000. Another article shows that BMW is being hurt in competing in the US market and abroad by the high value of the Euro.

2) Chrysler's new ownership group is robustly optimistic about the company's restructuring program, despite current financial losses.

3) By contrast, Honda's top management is looking forward to record sales and profits in the coming year.

A little clarification about the high value of the euro in dollar terms, and to an extent, a similar if much smaller rise of the Yen, follows.

First the Already Visible and Rapidly Growing Benefits for the US Economy

1. With a delay as contracts are rewritten, there has been a big burst of US export sales world-wide, and not just in the Eurozone. It's this growing and powerful stimulus to GDP growth itself that will --- along with more vigorous consumer spending at home (already captured in current data) --- that will likely keep the US out of recession in 2008 and produce a solid year of economic advance


Note, though, that US imports from abroad haven't fallen as fast and won't likely do so in the near future, especially if the dollar stabilizes against the Euro, Yen, and Canadian $. For one thing, our biggest purchases by far are of Chinese imports, and the Chinese government sells Yen and buys dollars (which it invests largely in this country in US government bonds) to keep the Yen from rising against the dollar. For another thing, some imports like foreign oil can't be quickly reduced even as its price has risen sharply because we can't easily substitute for domestic production and, more important still, it takes time to change driving habits, sell gas guzzlers for better mileage cars, car-pool, or use public transportation. For another thing, the US market is so important to many foreign companies that they'll reduce their profit margins here to keep their sales from falling much or try to cut the costs of their production abroad. Over enough time, however, more and more foreign companies will have no choice but to relocate more production here or accept a growing loss of sales.

2. If the dollar/euro exchange rate --- and to a more limited extent, the dollar/yen rate --- looks like staying low for a few years or more, then, to elaborate on the last point, EU and Japanese manufacturers will move more and more production to the US to take advantage of lower US labor costs. This has already happened with the European Airbus: its company --- already in financial trouble --- announced last month that it has no choice but to outsource more and more production to the US. Oppositely, the pace at which US-based manufacturers will move their production abroad will slow somewhat, all depending in the next two or three years on what will happen to the dollar/Chinese yuan rate.

3. Americans can expect ever larger numbers of tourists and even short-term shopping buyers from the Eurozone and --- as already has been happening --- from Canada. Oppositely, as American tourists find how expensive it is to travel in Europe (and to an extent in Canada), the overall boost to the US trade balance in services will turn even more positive than it usually has been. For that matter, come to think of it, you can expect more and more Europeans, Canadians, and even possibly Japanese to buy American housing, helping (admittedly in limited ways) to keep American housing prices from falling as much as they might in certain international cities here as well as tourist resorts.

The Possible Costs

As with everything that goes on in economic life, any changes have to be evaluated for the downside too. There are always tradeoffs, you see.

1. The US as a nation is less wealthy worldwide with a lower dollar, with US consumers and producers unable to afford to buy as many imports as before. The tradeoff benefit is that where there are domestic substitutes, demand for them will go up . . . including, over time, relocated European and Asian goods produced more and more in this country.

2. Despite what the average guy and girl on the street think --- and what most of the media reinforce --- the US balance of payments isn't driven by the current account (trade in goods and services) but by the counter-balancing capital account (short and long-term investment flows). These investment flows --- in and out of the US --- are far greater daily in total than import and export sales. From a low dollar exchange rate with the German Mark (to which all Eurozone countries were tied) and the Japanese Yen in 1991, the dollar skyrocketed in value throughout the 1990s and into the current decade. The reason? Ever larger purchases by foreign companies, private groups and individuals, and governments of US stocks, real estate, companies, and US government bonds.

A lower dollar indicates that such purchases of US financial assets have tapered off as foreigners readjust their financial portfolios and shift dollar-denominated stocks and bonds to Euros (and Pounds and Swiss Francs and Japanese yen to an extent). This tendency toward lower purchases of US financial assets means that, if it continues very long, it will likely put pressure on US short-term and maybe even long-term interest rates. (Such purchases by foreigners of US bonds, for instance, represent an inflow of capital to supplement US savings, the rate on which savings has been low for the last 15 years or so, compared to past periods. More precisely, there haven't been enough savings generated domestically to meet all our investment needs --- by companies or by private households that buy long-term durable goods like houses.)

How serious these pressures will be on US interest rates is, in my view, exaggerated --- not just by media coverage but by many economists who, bluntly put, have biased grievances against the current Republican administration (for which I myself didn't vote, either in 2000 or 2004). The reason for my optimism? The dollar soared in value in the first part of the 1980s, just as it has since 1991 . . . to the point that the US Treasury worked with its counterparts in Germany and Japan to try reducing the exchange rate of the US dollar compared to the Yen and D-Mark. That was exactly what happened. Between 1986 and 1991, the dollar fell roughly 50-60% against the Yen and D-Mark, during which period US exports doubled in value. Did capital inflows from abroad fall off? Yes . . . but then the 10-year benchmark US bond's interest rate actually declined somewhat in this five year period, rather than rise.

3. Another possible cost of a falling dollar is that those imports for which we can't easily find substitutes in this country in the short-term --- e.g, foreign oil --- might increase inflation pressures and force the Federal Reserve to try offsetting them by raising short-term interest rates. (The Fed can control such short-term rates; long-term rates are determined by the private markets for the supply of capital and the demand for its use by companies and households.) This danger can't be brushed off, but again the evidence of the late 1980s and early 1990s is encouraging here: despite the rapid fall of the dollar against the Yen and D-Mark, US inflation rates went down throughout that period, and this was all at a time of greater inflationary pressures generally.

The next article in this mini-series on the US dollar and the balance of payments will look more directly at why the $ has fallen less sharply against the Japanese yen and not at all against the Chinese Yuan.

PS: For a survey of misleading myths about the US economy --- especially how the huge middle class is being squeezed by globalizing trends (plus our economy's transformation into a high-tech information-based one) --- click here for an article in the Washington Post/