When Treasury Secretary Steven Mnuchin said to his Davos audience, “Obviously a weaker dollar is good for us as it relates to trade and opportunities,” and added that the dollar’s short-term value is, “not a concern of ours at all,” he thought that he was just stating a fact that everyone in the audience knew to be true. That is, the U.S. was not going to overreact to fluctuations in the foreign exchange markets or initiate policies to lower the dollar’s value.
The foreign exchange markets went into full fluster over his words, though, reading into them a monetary policy change to a weaker dollar — presumably to encourage exports. The U.S. Dollar Index, which measures our currency in comparison to a group of six foreign currencies, dropped to its lowest level since 2005.
President Donald Trump, not wanting the U.S. seen to be manipulating its currency — especially after criticizing China for doing exactly that — quickly moved to assure the global financial markets that Mnuchin’s words had been misinterpreted. In some respects, the president’s statement was more ambiguous about future U.S. monetary policy than his treasury secretary’s, but apparently his words were what the markets wanted to hear. The dollar quickly strengthened, recovered what it had lost the previous day, and added a small gain as well.
The ultimate determination on whether we have a strong dollar or a weak one is made in the foreign exchange market. That is where the dollar’s value is subjected to the forces of supply and demand.
The foreign exchange market is huge, with over $5 trillion changing hands each day. It is a decentralized market, though, dominated by insiders, and tends to be opaque to observers.
The market value of any country’s currency at any given time is driven principally by four forces: the strength of its economy and its prospects for growth; the country’s stability and credit risk; the inflation rate outlook; the interest rate and monetary policy affecting it. The starting point for these forces is the currency’s relative purchasing power. Through the market’s give and take, eventually the forces are reflected in the exchange rate for the currency.
The forces are economic in nature and we might expect economic analysis to play a big part in foreign exchange trading. It does, but despite long periods of unexciting logic and rationality the “animal spirits” often make the market as skittish as a herd of cattle in an electrical storm.
Much of the foreign exchange market’s volume is rooted in commercial trade; more specifically by the desire of business enterprises to hedge or eliminate their foreign currency exposure and risk. They do this through foreign currency swaps, and these account for over half the daily transaction volume. Mixed in with the commerce-driven swaps are risk-takers speculating that their view of the future is superior to that held by others.
The difference between a strong dollar and a weak dollar is measured by the exchange rate. If the U. S dollar can buy more Euros today than it could last week we call it a strengthening dollar.
The purchasing power of the dollar becomes a key element in our overall economic policy. A strong dollar means that Americans traveling overseas can purchase lodging, meals, and consumer goods for less money. It also means, however, that American companies can purchase goods and services overseas instead of from U.S. companies — driving imports up and, along with it, our foreign trade deficit.
The price for a strong dollar is paid by domestic industries and employment, especially manufacturing, and by a net leakage of dollars overseas — dollars that could be spent and invested here at home. That is why so-called “protectionist” moves, such as tariffs or regulatory miasmas, are attractive to governments.
Protectionism does not make a lot of international friends, though, and in a world heavily populated with security threats to the U.S. as well as complex trade agreements and alliances, tariffs and currency manipulations are not a cost-free option.
Of course, a deliberately weak dollar doesn’t make any friends, either, for that makes foreign goods more expensive for both domestic consumers and those who travel abroad.
The “damned if you do and damned if you don’t” situation presents an economic policy problem by itself. And when we add that being in favor of a strong dollar is a political necessity, no sane politician is going to say, “I will take steps to ensure a weak dollar.”
The net result is that letting the U.S. dollar “float,” that is, allowing the foreign exchange market to determine its value, becomes a kind of default monetary policy. Surprisingly for a default, it is a sound economic policy in today’s world of still-growing global trade.
James McCusker is a Bothell economist, educator and consultant.