In ordinary times – times when interest rates are positive, inflation is a greater concern that deflation, and recovery from recessions is a foregone conclusion – the effect of a fiscal stimulus is usually to strengthen the currency of the country involved. It might reduce confidence in the currency, which would make the currency less valuable at any given interest rate, but it will normally cause the interest rate to rise enough to offset that effect.
In a sense this has to be true. A country running a fiscal deficit needs to attract enough capital to finance that deficit. By whatever means – generally by raising interest rates – it must make its currency attractive enough to attract that additional capital, and the value of the currency will rise as the demand for it increases.
Granted, there are other options. In theory, a country can finance an increased deficit internally, but this requires households or businesses to increase their saving enough to offset the deficit, which usually doesn’t happen. Or a country can try to create the necessary capital out of thin air by using monetary policy. In ordinary times that’s usually considered a bad idea because it tends to lead to inflation.
Needless to say, these aren’t ordinary times. Households and businesses are suddenly all too eager to save, and inflation risks are for the moment outweighed by deflation risks. The “natural” effect of a fiscal stimulus – to raise the value of the currency – doesn’t happen, because the stimulus is fully accommodated internally by monetary policy. In the absence of an explicit exchange rate policy, the value of the currency depends on the market’s judgments about what the uncertain future might hold.
There’s a certain poetic justice, though, in the behavior of exchange rates during ordinary times. If a country is spending recklessly and overstimulating the world economy, it gets punished with reduced export demand, the result of a strong currency. If a country is saving heavily and thereby facilitating investment throughout the world, it gets rewarded with increased export demand, the result of a weak currency.
In a time like the present, when real investment is out of favor and the demand for it is insufficient to absorb what the world wants to save, poetic justice would call for a reversal of the usual effects. Fiscal spending is good; fiscal spending is, in a sense, altruistic: the benefit accrues to the world economy – spending produces an international stimulus that helps absorb the world’s excess savings and avoid an economic implosion – but the cost is borne by the spending country, which (theoretically anyhow) will have to pay back the debt in the future. Poetic justice would ask that deficit spending be rewarded.
Fortunately, if some country – or let’s say some currency area – pigheadedly refuses to do its part to stimulate the world economy, the rest of the world may be in a position to supply the just punishment. Or, to put it in less moralistic terms, if one player refuses to give a stimulus voluntarily in the form of fiscal policy, the rest of the world may be able to take that stimulus in the form of exchange rate policy. Moreover, after insisting that an additional stimulus is not necessary, the resistant player will hardly be in a position to object to a policy that excludes them from the benefit of such additional stimuli arising elsewhere. If they are forced to provide a stimulus for themselves to offset the stimulus they are not receiving from the rest of the world, so much the better.
Abstractions aside, it’s time for the rest of the world – particularly the US – to start buying euros aggressively. By itself, the effect of the US fiscal stimulus will be to increase the demand for European products: governments in the US will buy machinery from Germany; the newly employed can celebrate with French wine; Americans who escape job loss won’t have to cancel their Italian vacation. It can hardly be considered unfair if we try to offset that effect by weakening our currency and encouraging some Americans to visit the Grand Canyon instead of the Colosseum.
Unfortunately this isn’t likely to happen. That old mantra, “A strong dollar is in our national interest,” still echoes through the air in the District of Columbia. Never mind that the strong dollar was largely responsible for the housing boom that led to the current bust. It was: the strong dollar encouraged Americans to buy from abroad and discouraged those abroad from buying from the US; as a result, the only way the Fed could induce a recovery was by cutting interest rates to levels that sparked a boom in housing. The rest, unfortunately, is history.
A strong dollar is not in our national interest. It is not in the world’s interest. It is not in the interest of justice. It is just wrong.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
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