Dean Baker on the Overvalued Dollar

Dean Baker was invited to provide the economic section of Undoing Bush: how to repair eight years of sabotage, bungling, and neglect:

Two economic calamities have occurred on George W. Bush’s watch. The first has been a radically overvalued dollar, which, it should be noted, is a legacy of the Clinton years: by the date of Bush’s inauguration in January 2001, the real value of the dollar was already 27 percent higher than its low in July of 1995, the surge due in part to the stock bubble, in part to the financial crises in East Asia and elsewhere, and in part to high-dollar cheerleading by the Clinton Administration’s treasury secretaries. And yet despite these unsustainable highs, Bush did almost nothing to reverse the run-up; the value of the dollar actually increased in 2002. It has fallen since then, but it is still 12 percent above its 1995 low. The problem that a high dollar poses for manufacturing is straightforward: if the dollar is expensive relative to other currencies, then it is very cheap for Americans to buy imported goods and very expensive for foreigners to buy U.S. exports. In effect, an overvalued dollar provides a subsidy to imports and imposes a tariff on exports. Not surprisingly, this high dollar has led to a rapidly rising trade deficit, which in 2006 grew to more than $760 billion, or nearly 6 percent of GDP. This, in turn, has been the major factor contributing to the loss since 2001 of 3 million manufacturing jobs, or more than a sixth of the entire sector.

As I found myself agreeing so far, I was awaiting for Dean to mention the other shoe aka the Federal budget deficit. But that’s not what he lists as the second economic calamity:

The other major economic disaster under Bush has been the unchecked growth of the housing bubble, and although this, too, was inherited from his predecessor, Bush in this case deserves an even greater share of the blame. By the start of the Bush Administration, housing prices (which over the prior forty years had just kept even with the overall rate of inflation) had on average, and after adjusting for inflation, risen approximately 23 percent over their mid-nineties levels – a substantial but still containable surge. In 2001, however, when the stock bubble collapsed, Alan Greenspan, the Federal Reserve Board chairman, seized on the expanding housing bubble as the best tool for boosting the economy out of the recession. He pushed the short-term interest rate down to 1.0 percent—the lowest level in almost fifty years – and, more important, assured investors of the safety of the housing market, telling Congress in the summer of 2002 that “recent sizable increases in home prices . . . reflect the effects on demand of low mortgage rates, immigration, and shortages of buildable land in some areas.” By 2006, prices were 73 percent higher than their pre-bubble values, for a total of more than $8 trillion in unsustainable wealth.

I’m confused. Did Dean think that the Federal Reserve should have run a contractionary monetary policy when the economy was weak a few years ago? Additionally, he is letting the fiscal irresponsibility of the Bush Administration off the hook when he does not mention that fiscal stimulus leads to less national savings – which is part of the explanation for the rise in the current account deficit. Dean does get around to mentioning fiscal policy:

One last point: although budget deficits are not as big a problem as is often claimed, it will be necessary to take back Bush’s tax cuts, which have reduced annual tax revenue by somewhere between $100 billion and $300 billion each year. Of course, the war, too, is a substantial drain, costing more than $100 billion a year at present, or nearly 1 percent of GDP. It should be noted that neither the tax cuts nor the war broke the bank: when President Bush leaves office, the country’s ratio of debt to GDP is projected to be 66 percent, still below the peak debt to GDP ratio of 67.3 percent that we hit in the mid-nineties.

Dean has the accounting correct but the role that fiscal policy has on interest rates and exchange rates is missing from this commentary.