Washington’s debt deal raised hope that the U.S. economic recovery might not be so doomed after all. But the threat of a looming debt downgrade remains, which could still increase borrowing rates and put a damper on U.S. growth, if it causes investors to ditch U.S. Treasuries in search of safer havens. And yet, the prospect of a weaker U.S. dollar — the other potential fallout of a downgrade — might actually do the economy some good. In fact, the value of the dollar internationally has already been falling for some time, which has helped the recovery keep its legs.
The dollar’s value fell 11% against a basket of 12 major currencies through May 2011, and it’s fallen by nearly a third over the past decade, according to a new paper out by Harvard economist Martin Feldstein for the National Bureau of Economic Research. That may seem odd, since inflation has been kept in check and U.S. officials are constantly touting their commitment to boosting the almighty U.S. dollar. But the real goal of American policymakers, says Feldstein, isn’t a strong dollar overall. It’s a strong dollar at home and a weak one abroad. So what exactly does that mean?
A strong dollar at home means maintaining low inflation rates so the average American can keep up their standard of living without feeling squeezed. Achieving low inflation involves keeping a lid on prices by adjusting interest rates, and this is something the Federal Reserve has managed fairly well, with the average inflation rate hovering around 3% in recent decades. But for businesses sending their goods abroad, a weak international dollar is actually the better way to go, since it makes American exports cheaper for foreign buyers. It also makes cheap imports from places like China more expensive for American consumers, which, on the whole, might not be such a bad thing, since U.S. households are mired in debt and need to increase their savings. To achieve a weak dollar abroad, the U.S. has pressured China to increase the value of its currency relative to the dollar (which, despite U.S. niggling, China has done gradually) and unleashed dollar-diluting Fed programs like quantitative easing.
According to Feldstein, the value of the dollar abroad is likely to keep on falling, and with the government’s blessing. Why? First off, the countries around the world that have built up dollar reserves did so as a way to keep their exports cheap while maintaining a rainy day fund for increasingly costly imports. But as the euro gained strength and prominence, countries started to diversify their dollar stashes into euros as a way to hedge their vast currency bets. Of course, the Greek crisis reversed that trend. But there are already signs of foreign investors inching back toward the euro. China, for one, has invested roughly 75% of its increased foreign assets this year in euros.
Another reason a dollar decline may continue is that we’ve got a lot of debt to burn. Meanwhile, countries like China, Switzerland, Japan and other Asian countries with large trade surpluses have room to increase their currencies’ values against the dollar. China’s goal of increasing consumer spending will also help things along, since China’s army of new consumers has yet to match its spending power with the country’s overall growth. Once Chinese consumers start spending more, their savings rate will fall, as will their stockpile of U.S. dollars.
These would all be welcome news. The U.S. needs an export boom to keep growing. Even though only 10% of U.S. GDP comes from exports, export growth has driven more than a third of the increase in U.S. GDP over the past year, notes Feldstein. And the downsides of a weaker dollar wouldn’t be so bad, he argues. Households — which often bear the costs of a declining currency since they lose their buying power abroad — don’t actually import that much (imports make up 16% of U.S. GDP). So a 20 percent fall in the dollar internationally would reduce incomes by, at most, a few percentage points, estimates Feldstein. Domestic prices would also stay in check, since U.S. workers, most of whom are no longer backed by unions, wouldn’t demand higher wages to make up for slightly rising domestic costs. (It’s when wages rise with prices that bad inflation starts to kick in.)
Of course, an export-led recovery would be harder on the average American than recoveries past, since, to some extent, standards of living would fall. But then, a difficult recovery is better than no recovery at all.