Why the dollar will weaken further: and without this decline, the U.S. economy is likely doomed.

Author:Feldstein, Martin

When it comes to the value of the dollar, the official mantra of the U.S. government is that "a strong dollar is good for America." Official "mantra" but not official policy. Neither the U.S. government nor the Federal Reserve does anything to strengthen the dollar or to prevent it from falling.

A more accurate description of American policy is to have a strong dollar at home and a competitive dollar abroad. A strong dollar at home means a low inflation rate that maintains the purchasing power of the dollar domestically. This is clearly the goal of the Federal Reserve and one that has been achieved reasonably well over the past three decades with an average inflation rate of 3 percent.

In contrast, the competitiveness of the dollar abroad requires a decline in the trade-weighted value of the dollar to make U.S. exports more attractive to foreign buyers and foreign goods less attractive to American consumers by reducing the relative price of American goods and services. The dollar has in fact fallen over the past several decades and fallen sharply in the past year despite the mantra favoring a strong dollar. And the fall in the international value of the dollar has not prevented maintaining the low inflation rate at home.

Here are the facts: In the twelve months through May of this year, the real trade-weighted value of the dollar fell 10.6 percent against the

Federal Reserve Bank's index of major currencies and 9.1 percent against the broader index of currencies that is also calculated by the Federal Reserve.

The government's willingness to allow this rapid decline of the dollar--and perhaps even to encourage it by urging the Chinese to cause the dollar to depreciate relative to the renminbi and by the Fed's policy of quantitative easing--shows that U.S. dollar policy is more about achieving a competitive dollar than about a strong international value of the dollar.

The same is true if we look at the dollar's performance over a longer period. Over the past ten years, the real trade-weighted value of the dollar fell 31 percent against the index of major currencies and 26 percent against the Federal Reserve's broader index of currencies.


But what of the future? There are four major reasons why the dollar is likely to continue falling for at least the next few years. Note that I am not advocating policies to make that happen. I am just looking at the fundamental economic forces that I believe will cause that continued decline to occur.

The primary reason is that major investors around the world want fewer dollars in their portfolios. The major fund managers in Asia, in the Middle East, and elsewhere who are responsible for sovereign wealth funds and for national pension funds generally believe that they are overweight dollars and want to diversify their portfolios away from that overconcentration on dollar securities.

Those governments accumulated large amounts of foreign exchange as a result of trade surpluses. In some countries, this was caused by undervalued exchange rates that led to increased exports and reduced imports. In the oil-producing countries, it was the result of the rapid rise in the price of oil. The relevant officials in those countries initially regarded these foreign exchange holdings as traditional reserves to be held as a way of bridging any future gap between the cost of imports and the country's export earnings.

Eventually, however, these countries recognized that they did not need such large amounts of foreign exchange to bridge the temporary import-export gaps that might arise in the future. Korea, Taiwan, Singapore, and others with more than $200 billion in foreign exchange each came to understand that only a small portion of that was needed for the traditional purpose of foreign exchange reserves. That is even more relevant for the major oil producing countries, and for China with $3 trillion of foreign exchange.

Once they recognized that these were really important national investment funds, they asked themselves in what currencies they should be held, in what asset classes, in what maturities. The traditional investment in short-term U.S. Treasury bills ceased to make sense.

So they began...

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