Brad Setser on the Perils of a Weak Dollar

I was at first surprised by the title of this given how Brad has argued that a devalued dollar would raise our net exports. As I read it, it seems Brad has not changed his mind. Rather he is challenging the excuses offered by foreign governments to avoid the effects of their currencies appreciating with respect to the dollar:

In this context, the fall of the dollar is not a surprise. But even as the dollar has fallen significantly against the euro, the pound, and the Canadian dollar, the world’s rapidly growing emerging economies have resisted market pressure for their currencies to rise against the dollar. The resulting growth in these economies’ foreign-currency reserves has helped finance the US deficit. Too many countries with strong economies now have weak currencies, which puts strain on the world’s economy and financial system. It is better to produce goods – or financial assets – that can be sold at a premium in the global market than to produce goods and financial assets that must be sold at a discount. On the other hand, a weak dollar should help spur exports at a time when fewer Americans will be employed building and selling homes. Europeans will start to find the United States an attractive location for factories, not just shopping excursions. German auto firms already are increasing investment in the United States. The alternative to a weak dollar is a US monetary policy aimed at supporting the dollar rather than stabilizing economic activity in the United States – an even less attractive option. The United States now trades far more with Asia than with Europe and spends far more on imported oil than on imported European luxury goods. However, the central banks in the large emerging Asian economies and the major oil exporters generally have not allowed their currencies to rise by much against the dollar, even though their economies are growing faster than either the European or US economy. While a weak currency helps these countries’ exports, it is now contributing to a host of other economic problems. Inflation is rising. Real interest rates – the cost of borrowing less the inflation rate – are often now negative. The fact that the dollar hasn’t fallen against the parts of the world with the fastest growth has put additional pressure on Europe. Europe would be far better positioned to sustain its expansion – helping to offset the US slowdown – if the euro were strong only relative to the dollar, not strong relative to both the dollar and the currencies of most of Asia.

Brad concludes with something I find impossible to disagree with:

Global policy makers should start to think seriously about the best way to exit from a system where a number of countries around the world, in very different economic circumstances than the United States, are importing the consequences of the weak dollar. This above all requires a greater willingness on the part of those countries now intervening most heavily in the foreign exchange market to allow their currencies to appreciate. But it also probably requires far more cooperation among the major economies than has been the case recently.

The next President will need to restore our place among nations in diplomatic discussions for a variety of reasons. Brad points out that they may be economic benefits well beyond getting to exit Iraq. It would be nice if the current President started laying some of the ground work for this but I’m not holding my breath.