In his recent WSJ column “Strong Dollar Wins the Inflation Battle in New Spin on Currency Wars,” James Mackintosh suggests that the dollar’s sharp appreciation in recent years has been good for America and may be part of “an essential rebalancing of the global economy.”
The costs of a bloated dollar are very high. Trade deficits reflect a waste of America’s valuable resources, and the debts we incur to cover trade deficits are a burden that we shift onto future generations so that we can consume more than we produce. Besides being terribly inefficient, this is morally wrong. We are stealing from our children.
This note shows that the seriously overvalued dollar is hurting America and that the dollar’s recent appreciation is making global imbalances worse, not better as Mackintosh suggests. It further shows that, while raising interest rates and quantitative tightening are clearly needed to fight inflation, these measures will sharply increase the risk of a recession unless America’s international monetary policies are adjusted as soon as possible to moderate money inflows from abroad.
It concludes by recommending immediate implementation of a Market Access Charge (MAC), a new monetary policy tool that would make it far easier for the Fed to fight inflation with its traditional interest rate and quantitative tightening tools without triggering a recession.
1. What overvaluation means, and why it is bad.
While measuring the degree of currency misalignment requires far more sophisticated tools than the “Big MAC Index,” for example the presence of “currency overvaluation” is easily defined: If a country consistently spends significantly more on imports than it earns with exports, its currency is overvalued. The United States has had significant and sometimes serious trade deficits for almost fifty years – a record for a major country. It is therefore obvious that the dollar is overvalued and that we should worry. Why?
Financial Problems. Generally speaking, if a trade deficit is large, this can cause the country serious financial problems because, if the country becomes unable to pay its creditors in a timely manner, it may lose access to international capital markets. While the risk of this happening to the United States is limited because we can borrow in dollars and can “print” dollars to repay our loans, we still face at least two very real risks.
First, America already holds the world’s largest net debt to foreigners as measured by its net international investment position (NIIP), and this burden is rising quickly. According to the latest IMF assessment, America’s net foreign debt averaged 43 percent of GDP during 2015–18 and increased from 52 percent to 67 percent of GDP between 2019 and 2020.
Second, to “print” the dollars needed to repay its foreign debts, the US government will probably have to increase the debt ceiling or make cuts in other programs. If America’s increasingly polarized Congress finds it impossible to pass the needed budget legislation in a timely manner, this could mean a lower credit rating and higher borrowing costs.
In fact, the US was stripped of its AAA credit rating by S&P in 2011 for precisely this reason. If repeated in the future because of similar political problems, such downgrades could make creditors reluctant to lend to America, and this could easily increase the government’s cost of borrowing and its need to borrow.
Economic and Social Problems. Far more important for America than the risk of a default or a credit downgrade are the economic and social problems that the dollar’s overvaluation is causing.
By definition, large trade deficits reflect a serious underutilization of America’s productive capacity including its labor force. Trade deficits reveal that American goods find it hard to compete domestically against imports or as exports for foreign markets. As a result, sales of Made-in-America goods slow or decline, causing declines in domestic production, employment, profits, investment, and productivity. Meanwhile, foreign competitors thrive. The “China Shock” that has been documented in detail by Autor/Dorn/Hanson indicates that this has been a serious problem for America for years.
An overvalued dollar also reduces the effectiveness and thus increases the cost of stimulus programs. For example, stimulus payments issued during the COVID recession triggered a big increase in imports from China (despite the tariffs introduced earlier on Chinese goods), and US production fell during the recession. The result: the highest inflation in decades.
Excessive appreciation of the dollar is also an important source of serious social costs. Because output and employment are reduced – especially for those working in manufacturing and other sectors producing internationally traded goods, too many Americans live in poverty. Income inequality and political polarization increase. Too many Americans find it hard to obtain good healthcare, education, old-age security, and public transportation. Entire communities have been devastated when local factories can no longer compete with imported goods. Furthermore, burdens on future generations will be heavier. In fact, America is already suffering reduced intergenerational upward mobility.
2. Measuring the degree of the dollar’s overvaluation
As Blanchard and others have rightly noted, no single magic number can show if a currency is seriously over- or under-valued. But there are best-practice methodologies designed specifically to (a) see if the dollar and other currencies are priced at trade-balancing exchange rates, and (b) measure the degree of misalignment.
Three tools stand out:
- Fundamental Equilibrium Exchange Rate (FEER) tools developed by John Williamson and Bill Cline at the Peterson Institute for International Economics (PIIE) to support their “Current State of Currencies” report.
- External Balance Assessment (EBA) methodology developed by the IMF in the context of its annual External Sector Report (ESR) series. for its policy-focused work with member countries on their exchange rate policies. Unlike the PIIE, the IMF regularly updates and publishes its exchange rate balance assessments.
- True-Zero Trade Balance and the MAC (CPA). Jeff Ferry and the Coalition for a Prosperous America (CPA) Economics Team have created a very useful model to estimate the impact of the Market Access Charge on US exchange rates and trade balances. Using econometric logic similar to that used in the PIIE and IMF models, it provides direct measures of the dollar’s overvaluation as well as insights regarding the best way to reduce the overvaluation.
The IMF’s most recent ESR reports that America’s external balance has been “weaker than implied by fundamentals” since 2014 and that, to meet appropriate (near-zero) targets for trade deficits in coming years, the United States should devalue the dollar by up to 11 percent. This number is somewhat lower what is shown in the Ferry/Byers model but is in the same general range. (Note: The IMF and CPA models are now about a year out of date and will need to be rerun with data reflecting the dollar’s eight percent appreciation over during the past twelve months and the fact that the US trade deficit more than doubled in the past two years.)
In sum, America’s nearly fifty years of often serious trade deficits, which has led to America’s having the world’s largest net debt to foreign creditors of any country in the world, proves beyond doubt that the dollar is overvalued. Thanks to the work of the PIIE, the IMF, and the CPA, there are abundant resources to which we can refer for solid quantitative evidence regarding the severity of America’s trade deficits. Gimmicks like the Economist’s Big MAC Index, and the more solid purchasing power parity work of the International Comparisons Project, should only be used when comparing, for example, real per capita consumption across countries.
3. The dollar’s overvaluation is making global imbalances worse, not better.
Mackintosh of the Wall Street Journal suggests that the dollar’s recent appreciation may be “part of the essential rebalancing of the global economy.” This is highly unlikely.
“Global economic balance” refers to external trade balances measured, for example, as the sum of global trade deficits as a share of global GDP. The US already has such large trade deficits that it often accounts for more of the world’s total trade imbalances than any other country. How could further increasing the dollar’s overvaluation and thus trade deficits possibly contribute to “rebalancing of the global economy”?
4. The Fed’s anti-inflation measures, though needed, will sharply increase the risk of another recession.
The COVID pandemic and recession created a clear need for policies to support family incomes and to stimulate economic activity. Opinions vary as to whether payments under legislation such as the Coronavirus Aid, Relief, and Economic Security Act, the Tax Relief Act of 2020, and the American Rescue Plan Act of 2021 were of optimal size, but demand-side shocks (the stimulus payments) and supply side shocks (factory shutdowns and supply chain transport disruptions) have led to some of the highest rates of inflation in America for years. This inflation needs to be controlled before inflationary expectations become embedded creating a more permanent wage/price spiral.
However, the required policies such as higher interest rates and quantitative tightening increase three significant risks that could easily bring on another recession by raising the cost of borrowing and by driving up the dollar’s exchange rate.
· Higher Federal Reserve interest rates will reduce consumer expenditures and corporate investments.
Companies need to borrow to meet operational and investment needs, and individuals need to borrow to finance big-ticket purchases like cars and appliances. Higher interest rates and quantitative tightening will make credit more expensive and more difficult to get. This could well help trigger another recession.
· Higher US interest rates will increase the dollar’s overvaluation.
The spread between interest rates in America and abroad is increasing rapidly. This will attract foreign-source money into America, increasing foreign demand for dollars and dollar-based assets. The additional demand will put further upward pressure on the dollar, making Made-in-America goods less competitive here and abroad. Unless a policy is implemented to limit inflows of foreign-source money triggered by the growing interest rate spread, another recession, perhaps more severe than the last, will be inevitable.
· Foreign-source money less likely to cause recession if used for real investment.
The risk of foreign-source money creating recessionary pressures would be greatly reduced if, instead of going into financial investments, it went into real productive investments because (a) the inflows and investment expenditures would take place over a longer period, reducing the surge of new money circulating in the US economy, and (b) the real investments would increase supplies of consumer goods and intermediate products, thereby helping break the supply chain bottlenecks that contribute to higher inflation.
Unfortunately, real investments like these are not likely to be made with foreign-source money until Made-in-America goods become more profitable, and this will require implementing a policy such as the MAC that makes the dollar and thus American goods more competitive.
In short, in the absence of any policy tool to moderate the flow of foreign-source money into America, the foreign monetary impact of higher interest rates to fight inflation will kill demand for Made-in-America goods and stimulate the purchase of imported goods – a perfect recipe for triggering a recession. This is clearly another excellent reason for implementing, as soon as possible, a policy like the MAC that will move the dollar to a competitive, trade-balancing exchange rate.
5. Market Access Charge (MAC): The fundamental change urgently needed to reduce the risk of another recession.
The Market Access Charge (MAC), which forms the core of the Competitive Dollar for Jobs and Prosperity Act (CDJPA) that was presented to the Senate in the previous session, would assure that the world’s international currency markets, operating freely and with no quantitative constraints, would always keep the dollar close to an exchange rate that would allow Americans to earn as much producing exports as they spend on imports.
Paired with other trade and domestic industrial policies such as tariffs and sectoral development initiatives that would encourage the domestic production of goods needed to attain America’s key national goals, the MAC would help our country achieve the American Dream – the dream of steady, sustainable economic growth with benefits shared widely by all.
This is a beautiful dream, but will remain only a dream unless we implement a policy like the MAC that will keep the dollar close to rates that allow Americans to earn as much producing exports as they spend on imports.
 Williamson and Cline no longer work at the Peterson Institute and the institute has unfortunately discontinued its regular updates and publication of estimated fundamental equilibrium exchange rates (FEERs). However, individual reports are still available on the PIIE website, as is the model used to calculate the data for these reports.
 IMF, 2021.12.17, External Balance Assessment (EBA), Data and Estimates. https://www.imf.org/external/np/res/eba/data.htm