Weak Dollar Will Normalize Trade Imbalances and Unemployment

The best recent policy response to the financial crisis didn't come from the G20 but from the foreign exchange market. This week the dollar fell aggressively against many currencies, driven by an Australian rate increase and a report claiming Arabs, Chinese, and Russians were conspiring to stop pricing oil in dollars. But the dollar was set to depreciate anyway due to an increasing debt and a dovish Federal Reserve. A weak dollar will have a positive effect on normalizing trade imbalances, if it lasts.

A falling dollar is a great stimulus to the US manufacturing base. Historically, manufacturing profits are inversely related to the value of the dollar.

From 1990 to 1995, the dollar stayed around the same level. But in 1995, the dollar started rising steadily, eventually peaking in 2002 after rising 51%. During this time, exports decreased by half:
During this period, exports in China and Japan surged. China's reserves quadrupled and Japan's reserves almost tripled. (For more information, see Robert Blecker's paper, "The Benefits of a Weak Dollar" at the Economic Policy Institute.) The strong dollar also had a large effect on jobs. See this figure on the effect of China's artificially low currency on employment and trade:

The map below shows the damage per state (see Robert Scott's paper here). Note that politically sensitive states such as Ohio, Michigan, and Florida have suffered some of the biggest losses.
Simon Johnson from MIT wrote a recent article arguing the weaker dollar is a part of Obama's plan to win the midterm elections by stimulating the manufacturing industry. Simon says NY Fed President William Dudley's recent comment that interest rates would stay low for the foreseeable comment was timed to send the dollar lower after the Australian rate hike. If rates stay low in the US for longer than other countries, there is an opportunity for a carry trade between the dollar and a currency that is likely to increase rates sooner (e.g. Korea, Australia, China or Switzerland).

Fundamentally, the dollar has nowhere to go but down. With high fiscal debt, loose monetary policy, and trade deficits, the dollar is fundamentally unattractive. Furthermore, there is likely to be significantly less demand for dollars in the future. The second largest holder of US debt, Japan, is highly indebted (debt to GDP of 170%) and aging. The savings rate has been steadily decreasing and will continue to reduce demand. Furthermore, the number one holder of US debt, China, is actively (and publicly) trying to diversify from the dollar.

But while the dollar may go down and start to normalize trade in the short-term, there is reason to be skeptical that this will occur for longer periods of time. Asian nations will not let the dollar get too low. Already we have seen Asian countries respond to the falling dollar. Yesterday, the FT reported Asian central banks aggressively bought the dollar on Thursday. Thailand, Malaysia, Taiwan, Hong Kong, and Singapore made substantial purchases, though they merely slowed the dollar's decline. A key aspect of this intervention was that it was coordinated.

The Asian countries that intervened likely did so primarily to stay competitive with China, which re-pegged the renminbi to the dollar in July 2009. This re-pegging of the renminbi means that whenever the dollar significantly weakens, a large number of central banks must intervene if they want to compete with China. This could mean a floor for the dollar. It could also be a bullish indicator for US treasuries, as foreign central banks may buy treasuries to push the dollar higher.

Perspectives on Obama's Tire Tariff

Pres. Obama's recent 35% tax (on top of an existing 4% tariff) on tires imported from China has generally been denounced as a protectionist move motivated by domestic political factors. Bill Witherill of Cumberland Advisors called it a "cynical and dangerous move" because the US tire manufacturing industry is internationally uncompetitive anyway. Some have speculated the tariff will lead to another Smoot-Hawley effect on the world economy. With the lessons from the Great Depression hanging heavy over everyone's head, the recent trend of trade retaliation (such as competing Buy America and Buy China policies) is certainly alarming.

But while the tariff may seem ominous from an economic perspective, from a geopolitical perspective the tariff makes more sense. A recent article from Stratfor (which is unfortunately not public) argues the moves of both countries were politically motivated and are unlikely to escalate. I don't agree, but it's an interesting argument. First they point out this is not a normal WTO case, because Obama never even mentioned any unfair trade practices. Obama did it because he can. In the 2001 Chinese WTO accession agreement, Clinton insisted on including a particular section 421, which basically allows the US to sanction any product without making a case for trade violations until the end of 2013. For that reason, China cannot react in any way that will actually hurt the US, because it could provoke Obama to use section 421 again, completely legally. We have yet to see any meaningful retaliation. China declared it would probe "unfair practices" in US chicken and auto products, but that's it.

But why would Obama do this for domestic political reasons as the FT, WSJ, Stratfor, and others have claimed? Sure he's having trouble with healthcare, but why would he trade a small boost in his base for further complications in Iran? As Stratfor points out, China could easily retaliate by refusing to cooperate with sanctions or stonewalling negotiations. But this would make Obama look terrible. Obama has a lot of political capital riding on Iran. His criticism of Bush's unipolar attitude and unwillingness to negotiate was one of his main foreign policy selling points during the campaign. I think its more likely Obama enacted the duty to remind China of its economic leverage before the P5+1 negotiations with Iran. China is not enthused about sanctioning its third-largest supplier of oil.

Obama said on Wall Street this Monday,

"Make no mistake, this administration is committed to pursuing expanded trade and new trade agreements. It is absolutely essential to our economic system. But no trading system will work if we fail to enforce our trade agreements. So when, as happened this weekend, we invoke provisions of existing agreements, we do so not to be provocative or to promote self-defeating protectionism. We do so because enforcing trade agreements is part and parcel of maintaining an open and free trading system."

These words imply the US sees its ability to tariff-at-will as a right in return for opening up trade with China. While his choice of industry might have been politically motivated, his decision to raise tariffs in the first place was likely a geopolitical one. It will be interesting to see how the trade and Iran issues evolve alongside each other.