Last week the U.S. Treasury Department took the unusual step of labeling both Switzerland and Viet Nam currency manipulators. If the accusation stands, the two countries will then need to come to an agreement with the U.S. and the IMF or face possible retaliatory tariffs. The mainstream press has, as always, focused on reasons for, as well as the possible consequences of, the artificial currency deflation by the two countries. And as someone asked by many a puzzled student why currency values matter, I sort of get why. So, while I think that the broader exchange rate context is much more important, let me begin by going over some basics.
The United States accuses the Swiss central bank of intervening in currency markets by buying forex (mostly euros and dollars) and selling Swiss francs. Doing so artificially depresses the value of the franc relative to the other currencies. The principal advantage to Switzerland is that a weaker franc encourages foreign investment. It also makes its exports more competitive. What concerns the U.S. is that a weaker franc means that the dollar is relatively stronger, weakening its exports and discouraging foreign investment.
The odd thing about the U.S. claims is that the dollar has recently been falling vis-à-vis both the Swiss franc and the Vietnamese dong. The Swiss franc has appreciated 2.5 percent compared to the dollar over the past month, and 9.3 percent year to date. And there is also not much evidence of a weaker dong, which indeed would help Vietnamese export competitiveness. On the contrary, since April 13th it is in fact the dollar that is 2.1 percent lower with respect to the dong.
It is true that the dong has weakened relative to the dollar over the longer term, which is why it would be smart to keep in mind the broad context. The dong is down 4.2 percent vis-à-vis the dollar over the past year, 37.7 percent over ten years, and 53.2 percent since 2003. But this is hardly unusual. Non-convertible currencies always tend to slide in value over time in relation to the hard forex currencies. If you want to know why, you will need to keep abreast of my posts. All I can offer here is the short answer: global inequality, trade imbalances, and economic dependency.
But in the case of the Swiss franc, we are talking about a hard currency that rivals the dollar. And here, it is clear that the dollar has been weakening. In fact, the dollar has on the whole been falling in value in relation to all the major currencies (see Chart). Compared to the Swiss franc, the dollar has steadily declined in value since 2000, and is now at barely half its strength compared to 20 years ago. Against the pound sterling it is only over the past five years that the dollar has lost value; the dollar has in fact gained eight percent over the longer term. And even though the dollar is higher vis-à-vis both the Euro and Yen compared to a trough about a decade ago, it is lower both in the longer term and in recent years.
Of what is a falling dollar a sign? If there is scant demand for U.S. exports, fewer dollars are demanded. The same is true if foreign investors retrench. While the latter does not appear to be a problem, U.S. exports have been weak for decades. On balance, then, there has been downward pressure on the dollar for quite some years. A falling dollar should, however, be self-correcting since it ought to both boost exports and attract foreign investment. But as economists are wont to declare, it assumes ceteris is paribus – i.e., everything else is unchanging. It is, alas, not the world we inhabit.
The United States has benefitted immeasurably from its geopolitical hegemony over the past 50-60 years. Its global dominance after World War II helped the dollar gain reserve currency status after the collapse of the gold-exchange standard in 1971. With the dollar as the global currency par excellence, the United States has mostly been free to run record deficits in its role as consumer of last resort – thus artificially propping up the standard of living of most Americans.
What are we likely to see going forward? Prediction is a fool’s game, but there are at least a few reasons to expect the dollar to continue falling. First, there is no question that U.S. hegemony is on the decline. The ascendancy of China and Russia and challenges from “lesser” foes like Iran threaten to destabilize the United States. To the extent that economic challenges from its rivals are effective, the dollar’s position as the premier global currency will grow increasingly tenuous.
Second, keep in mind that the dollar has declined against other major currencies this year despite all the economic chaos and uncertainty. Historically the dollar has served investors as insurance against uncertainty, because the U.S. economy is generally considered a better bet than most. So it is that much more remarkable that the dollar has depreciated over the course of the year. Third, the negative real interest rates pursued by the Fed only weaken the dollar further, by discouraging investment from abroad. One could argue that it would be tempered somewhat by similar policy being followed by other major central banks in these desperate times. But to the extent it is so, it also means that more foreign capital is likely to flow to emerging markets or even commodities such as gold.
Finally, with its budget and current account deficits sizable and growing, there will be continued pressure on the U.S. to depreciate the dollar in order to finance them. In other words, a cheaper dollar would help U.S. exports (good for current account) and foreign demand for U.S. Treasury bonds (which helps finance the national debt).
But the global imbalances that the twin deficits and dollar sovereignty have created are not sustainable. While they continue to intensify, it all appears to presage a reckoning of some form, probably more calamitous the longer it is postponed.