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Competitive Devaluation

By James H. Nolt

Donald Trump has a huge problem as he enters office, given what he promised the American people. The problem is the strong dollar. A strong dollar sounds like a good thing, but like everything in political economy, it is good for some and bad for others. A strong dollar means that everything priced in dollars is expensive for foreigners; conversely, everything priced in foreign currencies is cheap in the U.S.

This is very bad for the balance of trade and American jobs, as Trump has been lambasting throughout his presidential campaign. Higher-priced American goods mean foreigners buy less, reducing American exports. Lower-priced foreign goods mean Americans import more and buy fewer things made in America. The rise of the relative value of the dollar during the past year has already had a significant impact in worsening the balance of trade.

On the other hand, a strong dollar is generally good for creditors who own dollar debts either in the form of bonds or loans. If the dollar debt is lent to foreigners, then they are more distressed because their earnings are likely in their own currency, whose value is falling compared to the rising burden of their dollar debts. In round numbers, there are over $60 trillion in dollar debts that become more valuable for their owners as the dollar strengthens, but this currency effect can also be counteracted by falling bond values if yields spike.

There is thus a parallel with what I discussed earlier about price wars emerging among debt-strapped companies. This week I extend that to exchange rates, the price of everything denominated in a currency, and how a similar dynamic can lead to another kind of “race to the bottom” resulting in competitive currency devaluations.

Introducing various currencies introduces some complexity, so be sure to keep in mind that all prices here are relative, not absolute. That is, prices are just ratios at which things exchange. The dollar has strengthened during 2016 and will likely to continue to strengthen during 2017, which means that one dollar can buy more and more things priced in other currencies like euros, yen, pounds, pesos, and Chinese RMB. It is as if everything made abroad and all foreign assets are on sale.

Several factors are causing the dollar to strengthen. Although the U.S. government may seem to be borrowing a lot, foreigners in Europe, Japan, and China are borrowing even faster, at a feverish rate. Such high borrowing is facilitated by the central banks of these regions because they keep buying bonds to keep bond yields (equivalent to interest rates) low. This is often called “printing money” or “quantitative easing,” but both of these are misnomers for what is really a bond-buying spree.

All this bond buying keeps demand for bonds high and yields low. Yields on some European and Japanese bonds have even gone negative, which when I took economics four decades ago was considered impossible. Investors seeking higher yield look to the U.S. Even though its interest rates are at historic lows, too, they are not as low as in Europe and Japan. Furthermore, since the dollar is expected to strengthen in the near future, foreigners would rather own dollar assets than assets in their own currency.

Last week’s decision by the U.S. central bank, the Federal Reserve, to raise its short-term interest rate target by 0.25 percent may seem small, but since many other major countries continue to hold rates low, it is enough to attract more foreign investors to seek dollar assets, including bonds. Furthermore, Fed chair Janet Yellen suggested that four more quarter-point increases are likely during 2017. This leads investors to expect the dollar to continue its upward trend during the coming year. As I said, this is good news for owners of dollar debts and very bad news for American industrial workers and for Trump’s campaign promise to bring manufacturing jobs back to America.

Bernie Sanders campaigned for president against the “billionaire class.” However, there are some important distinctions between billionaires and other wealthy people. Most real estate moguls like Trump are net debtors. That is, they are in the business of borrowing money to buy and develop real estate, expecting to make money if the developed property can be sold for more than the cost of the borrowed capital used to acquire it. The more expensive it is to borrow money, the more property values must rise in order for real estate investors to make money. This is reinforced by the fact that if rates rise and credit tightens, real estate prices stop rising because it is more difficult for others to borrow and buy. A real estate price boom is sustained by easy credit and crashes when the cost of borrowing spikes. Therefore rising interest rates and the consequent strengthening of the dollar are bad for Trump’s job promises (which some argue he does not take seriously), but also for his own business interests and those of his developer friends.

On the other hand, many of the “billionaire class” as well as many financial institutions are net creditors. That is, they are in the business of owning loans to others. A strong dollar is generally good news for them. Their dollar assets gaining relative value also means that foreign assets look cheap. They are selling at a discount. Investors might thus exchange some of their dollar assets for discounted assets abroad.

But as is so often the case in political economy, expectations matter a lot. If the strength of the dollar and the weakness of other major currencies is temporary, then it is a good time to buy foreign assets at a discount and profit when the dollar falls again in the future. On the other hand, if relative prices are moving sharply, it would be wise to wait to buy the falling asset until it bottoms out rather than pay too much for it now. Furthermore, if the change in relative values is not temporary, but a permanent secular trend, then it is unwise to acquire the falling asset at all.

Trump’s own business interests and his campaign promises align with higher borrowing, lower interest rates, and a weaker dollar. As I argued in a previous blog, Trump will be hamstrung by the likely strengthening of the dollar during 2017. He promises to cut taxes and yet increase several areas of spending. In combination, this will add to government borrowing. It may be difficult to coax investors to buy so many more government bonds without sweetening the deal with higher yields. Yet higher interest rates tend to strengthen the dollar and add to the burden of debtors like Trump himself.

The solution to this problem may come in February 2018, when Janet Yellen’s term as Fed chair ends. Trump will then nominate a new chair—perhaps one more to his liking. An easy prediction is that the 2018 Fed will try desperately to facilitate Trump’s economic program of low interest rates and a weak dollar by going on a bond-buying spree like those in Europe and Japan.

This would mean that all major currencies would be “racing to the bottom,” trying to keep their currency from rising relative to everyone else’s currency. This sort of competitive devaluation last occurred during the Great Depression of the 1930s. It quickly led to foreign exchange controls as governments with weaker currencies desperately tried to hang onto foreign exchange flowing out, fleeing weaker currencies for slightly stronger ones. Exchange controls accelerated a drastic contraction of trade as countries tried to conserve foreign exchange earnings for the most vital needs: avoiding default on foreign debt and importing inputs needed to keep economies running.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

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