Don’t Let the Dollar Inhibit Growth
By Sean Rushton, Wall Street Journal
Jan. 12, 2017
As the U.S. economy slowly recovers from its low-growth hangover following the 2008 financial crisis, the Federal Reserve is gradually tightening monetary policy. Meanwhile, President-elect Trump and the Republican Congress plan to spur growth through deregulation and cuts in corporate and personal income taxes. Yet the Reagan years proved policy makers should watch out for another threat to the improving economy: a soaring dollar.
In the early 1980s, the Fed’s tight monetary policy along with the Reagan administration’s tax cuts caused the dollar to rise dramatically relative to other major currencies, appreciating more than 50% from 1980-85. As the exchange rate soared, inflation plummeted from 13% in 1980 to below 4% in 1983, and stayed low—a stunning and welcome disinflation.
After the 1970s era of dollar depreciation and inflation, the rising dollar was a boon to consumers, and the supply-side policy mix associated with economists Robert Mundell and Arthur Laffer made the economy boom. In 1984 real GDP rose 7.3%.
Once inflation was down, however, the future Nobel winner Mundell and his ally New York Rep. Jack Kemp highlighted a new hazard: the skyrocketing dollar. The exchange rate’s sharp appreciation—necessary to get inflation down—meant falling profits for U.S. multinational companies, reduced competitiveness for domestic manufacturers of products such as autos and electronics, and steep declines in output prices for commodities such as oil, farm products and steel.
As a result, populist anger from both labor and management surged in the 1980s against global trade. Auto workers burned Japanese flags and smashed Japanese cars with sledgehammers; members of Congress demolished Japanese electronics on Capitol Hill; “Buy American” was the era’s slogan. The global financial system was destabilized as commodity-based economies were derailed and nations with large dollar-denominated debts—especially in Latin America—faced crises that left deep economic scars.
Today, conditions are similar enough to raise red flags. As I wrote in these pages in May 2011, Mr. Mundell argues that the 2008 crisis occurred because the Fed let monetary conditions become too tight. Consumer-price-index inflation plummeted—from 5.5% in June 2008 to zero by December 2008 and negative 2% by March 2009—and left the dollar overvalued and tending to soar each time the Fed ended its “quantitative easing” asset purchases.
This trend has continued, with the dollar up 25% against the euro since QE3 ended in 2014. Since the 2008 crisis, the expectation of dollar appreciation has kept the economy in malaise, preventing interest rates, inflation and GDP from normalizing, similar to Japan since the 1990s. Mr. Mundell believes, as do I, that restoring equilibrium requires breaking the expectation of a soaring dollar.
The higher dollar since 2015 has already hit U.S. multinational profits, domestic manufacturers and commodity producers. A long list of top U.S. companies, from Microsoft and IBM to Emerson Electric, Pfizer and Caterpillar, cited the dollar last year as a driver of disappointing earnings. In January 2016, Apple CEO Tim Cook told the Journal that due to the dollar’s rise, $100 in overseas revenue in 2014 translated to $85 in 2015. “When the currencies move to that degree for that period of time, it’s meaningful to us,” he said.
The appreciating dollar has also created default pressures for nations with large dollar debts. The Bank for International Settlements estimates the world held $9.7 trillion in dollar-denominated debt last year—and warns that widespread defaults in emerging markets could destabilize the global financial system. Governments with exchange-rate links to the dollar, such as China and Saudi Arabia, are under mounting pressure to cut their links and devalue their currencies. Use of capital controls by governments to stabilize capital flows is on the rise.
Now—with the Fed saying it will raise its target interest rate repeatedly in 2017, continued monetary easing in other large economies, and a new president promising big tax cuts in 2017—there’s a risk that the dollar will soar to dangerous heights. Since Election Day, the dollar is up more than 5%.
If the already-high dollar does rise significantly, how will it influence an economy with low inflation and low velocity of money, and still recovering from a deflationary financial crash? How will it affect U.S. exports, manufactures, commodities, and blue-collar jobs? How many global debt defaults will it generate, and how will they affect banks? Could a trade war erupt if China devalues by a large percentage in response? Will the soaring dollar offset the positive impact of supply-side fiscal policy, such as the Trump tax cuts? Or will markets tank in advance and force the Fed to retreat from normalizing interest rates?
In 1985, after much discussion by Mr. Mundell, Rep. Kemp and others, the Reagan administration addressed the high dollar in cooperation with other major economies. The Plaza Accord, negotiated by then-Treasury Secretary James Baker, lowered and stabilized the exchange rate. The period after 1985 is now fondly remembered as the “Great Moderation,” when inflation and interest rates were down, the dollar was moving into a healthy trading range, and global economic growth was strong. Protectionist pressures faded and trade expanded.
Another Plaza Accord may be needed to do the same for today’s far larger interdependent global economy. European Central Bank President Mario Draghi spoke of the need for greater currency alignment and stability at an ECB conference in June, saying, “In a globalized world, the global policy mix matters.”
Removing the prospect of big dollar swings would be an enormous benefit to the long-term productive economy. Less volatility among the large currencies, perhaps assisted with a common external target or shared monetary rule, would be a major step toward stabilizing our crisis-prone system, restoring normal interest rates, lowering trade frictions, and returning to broad-based economic growth.
Mr. Rushton, a former senior policy adviser in the U.S. Senate, is the director of the Project on Exchange Rates and the Dollar, in partnership with the Jack Kemp Foundation.