Feldstein on Monetary Policy and Exchange Rates

Martin Feldsteiin gets it right:

In reality, of course, the US does not have a dollar policy – other than letting the market determine its value. The US government does not intervene in the foreign exchange market to support the dollar, and the Federal Reserve’s monetary policy certainly is not directed toward such a goal. Nor is the Fed specifically aiming to lower the dollar’s value. Although cutting the Federal Funds interest rate from 5.25% in the summer of 2007 to 3% now contributes to dollar depreciation, this has been aimed at stimulating a weakening economy … the Treasury’s only explicit currency goal now is to press the Chinese to raise the value of the renminbi, thereby reducing the dollar’s global trade-weighted average. The pressure on China is, however, entirely consistent with the broader US policy of encouraging countries to allow the financial market to determine their currencies’ exchange rate. There is, of course, truth to the statement that a strong dollar benefits the American public, since it allows Americans to buy foreign products at a lower cost in dollars. But, while the declining dollar does reduce Americans’ purchasing power, the magnitude of this effect is not large, because imports account for only about 15% of US gross domestic product. A 20% dollar depreciation would therefore reduce Americans’ purchasing power by only 3%. At the same time, the lower dollar makes American products more competitive in global markets, leading to increased exports and reduced imports. The dollar has declined during the past two years against not only the euro but also against most other currencies, including the Japanese yen and the renminbi. On a real trade-weighted basis, the dollar is down about 13% relative to its value in March 2006. This improved competitiveness of American goods and services is needed to shrink the massive US trade deficit. Even with the dollar’s decline and the resulting 25% rise in US exports over the past two years, the US still had an annualized trade deficit at the end of fourth quarter of 2007 of about $700 billion (5% of GDP). Because US imports are nearly twice as large as US exports, it takes a 20% increase in exports to balance a 10% increase in imports. That means that the dollar must fall substantially further to shrink the trade deficit to a sustainable level.

Indeed – the dollar devaluation enhances the potency of expansionary monetary policy as it tries to alleviate the impending recession. While Feldstein concedes that European policy makers are concerned about the recent dollar devaluation, he notes:

Instead of simply wishing that the dollar would stop falling, European governments need to take steps to stimulate domestic demand to replace the loss of sales and jobs that will otherwise accompany the more competitive dollar. This is not an easy task, because the European Central Bank must remain vigilant about rising inflation, and because many EU countries maintain large fiscal deficits. While the ECB has limited room for maneuver, regulatory changes and revenue-neutral shifts in the tax structure (for example, a temporary investment tax credit financed by a temporary increase in the corporate tax rate) could provide the stimulus needed to offset declining net exports. It is therefore important that EU governments turn their attention to this challenge.

In other words – if there is a concern that European aggregate demand might also fall, let the European governments join the US in smart fiscal policy. Oh wait!