Why is dollar so high?

That is a question posed by Martin Feldstein in his latest paper and as usual he answers it pretty well. (For the uninitiated high means the currency is overvalued….say 1 dollar = Rs 40.50

There are a few economists who put across facts as simply as Feldstein does. The paper has no jargon, no stats and fuzzy maths. His papers are very short, up to the point (few references) and really focused.

First a few basics: (Y= Income, C= Consumption, I+ investment, G+ Govt. Expenditure, X + Exports, M= Imports)

The standard macro identity is: Y = C + I +G+ (X-M)
Now S = Y-C-G
hence S – I =  X-M

or in English, any gap between savings and investment is equal to the gap between exports and imports. So if savings are lower than investments than we have a trade deficit and hence we would need capital flows to finance the trade deficit or the savings-investment gap.

Now the paper summary:

In US we have a high trade deficit (almost $ 800 bn) which is a problem of either little savings or higher investment. As per him savings are low because of:

  • increasing wealth
  • mortgage financing

The puzzle deepens as Investment should fall given the low rate of savings. Feldstein has showed in his earlier paper that I does not drop given a fall in S in the short term. But then US has hade current account deficit for time immemorial.

To which he explains that ‘I’ continued to be high as interest rates did not increase. ( Higher r leads to lower I)  r did not increase as there were huge capital inflows from abroad via China (to maintain its currency), Japan (carry trade) and Middle east (oil).

So his take is that trade deficit would reduce if savings increase and USD depreciates. The former would happen over a period of time as we see wealth reducing (it is a cycle after all) and the latter would happen as Chinese and Japanese are already reconsidering their policies. Chinese are unhappy over huge dollar exposures and Japan is considering allowing interest rates to increase which would reduce yen-carry trade.

He says at the end that what would matter is what happens first whether USD depreciates or savings increase. His idea is it is better if former happens first as that would lead to lesser weakening of the national economy.

The paper is disappointing in 1 aspect. He says most papers (IMF in particular) mention that there is a need to reverse global imbalances i.e. a mix of events are needed- higher US savings, increased productivity in Europe (so capital flows shift a bit there),  Chinese exchange rate felxibility but none mention USD depreciation.

However, he does not  make it clear how the USD would depreciate. Now this is a point he does not make clear or provide references to. I don’t see Japan reducing rates as again signs of deflation have resurfaced and not much of the hype about interest rates rise has died down.

He says in the end:

The best hope for a smooth adjustment of both the global and U.S. imbalances would be a substantial fall of the dollar followed by a significant rise in the U.S. saving rate and a policy of fiscal stimulus in other countries. Achieving this will require both good policies and good luck.

Feldstein is a giant in the profession and I expected some better advice than good luck.  But the, it is the simple analysis by Feldstein that stands out.

4 Responses to “Why is dollar so high?”

  1. Competitive vs strong currency « Mostly Economics Says:

    […] has the same message he had given in his paper I covered here (The paper came in 2007) that dollar needs to depreciate to control trade deficit. He has […]

  2. Demographics could explain world imbalances « Mostly Economics Says:

    […] We all know US has huge trade deficits (and current account deficits) and it is financed by capital flows from mostly Asian countries. The current account deficit exists as US investments are higher than savings. I have summarised the entire story here. […]

  3. Feldstein on Housing Markets « Mostly Economics Says:

    […] as he puts his views in a very simple manner. I have covered a few of his papers and speeches here and […]

  4. Tony Says:

    In other words, on Feldstein’s opening the dollar is high because it has to be. That’s a very intellectual form of reeasoning. In other words it is not “free market forces” but control for a purpose, control at the expense of other countries…control by whom and what.??

    It is indisputable that the American government only has insular morality, it will do as it likes owing to political power through military force, to secure the world’s resources for itself and its Middle East masters. This is just another example. the place is an international mess, exposed as utterly deceitful in the whitehouse and yet sycophantic puppets follow it mindlessly into the abyss….welcoming the devaluing of our currencies as the USA feeds off us and the dollar continues to rise draining our resources and savings. Already Australian banks for one have, in my view criminally, raised borrowers rates to help pay for their crooked investments in the USA…something which the corporation and shareholders should pay. “raising interest from time to time” must have reasoning ptaining to the general monetary situation…not bad investments.

    Australian government interest in this indisputable fact?…absolutely nil…we are simply serfs in a new feudal system…pay taxes and bear arms for the barons. The government is a myopic apologist for US policy as Rudd is showing…mirroring the USA after many here have lost their homes through bad reserve bank decisions, reflecting its one line mindset from what are presented to us as experts in control (private control) of Australian’s futures. Well might one wonder about the notion of the level of intelligence which gazes adoringly at itself whilst “running the country”.

    Feldstein is right….the dollar US is where it is through skullduggery..it should be around 98cents Australian…almost parity as Australia’s government and policy are a US satellite and reflect the world wide disasters of the US invading Iraq whilst mayhem was allowed to proceed at home through banker’s greed and connivance in dishonesty in the sub prime scam.

    Ask yourself, who ends up with the long term investment property on foreclosure? and do you not think 700 billion dollars is merely a minor invest ment for banking consortiums….especially when they then bludge it from the taxpayers through increasing interest rates and through tax deductions. This is the USA at its most overtly corrupt…in the past it was hidden, at least now some smidgen of it is exposed but then, in closing, US power, egoism is so safe it can do as it likes to anyone anywhere and get away with it.

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