The Region

Exchange Roller Coasters: Where's the steering wheel, and does it work?

The strong dollar-weak dollar debate and the vagaries of currency exchange rate regimes.

Ronald A. Wirtz - Editor, fedgazette

Published December 1, 2002  |  December 2002 issue

What's green, goes up and down, has three digits, makes people scream and shout, and goes by the name George?

The answer, of course, is the dollar, whose value has induced some frenetic hand-wringing among businesses, financial markets and policymakers.

Through March of this year, the value of the dollar compared with other major currencies had stayed doggedly buoyant despite the recent recession and sluggish recovery. Some U.S. businesses were frantic. The strong dollar is killing exports, many screamed, flooding the United States with cheap goods and leading to record trade deficits.

In the summer, the dollar began to fall. Good news, yes? Hardly. Call it frantic times two. Advocates of a strong dollar said it meant cheap capital for U.S. businesses and was the engine of growth. A weak dollar will pull the rug out from any economic recovery.

Then the dollar rebounded against the yen, regaining about half its earlier loss by mid-October despite the possibility of a double-dip recession in the United States. Enough already.

People disagree—sometimes wildly—over whether a so-called strong dollar is preferable to a weak dollar, or vice versa. The dollar's levity, subsequent fall and modest rebound were all met with the contrarian opinions of being both wonderful and fatal. Both viewpoints are right, to a point; they might be better described as half-truths.

The issue ultimately delves deep into the vagaries of exchange rate systems—the age-old trading of one currency for another. Most of the world's currency, including the dollar, is governed today by a floating exchange rate, where markets dictate value. Under such a system, at least in theory, there is nothing good or bad about a weak or strong dollar, it is simply the price at which supply is equal to demand.

"The concepts of a 'strong' or 'weak' currency are meaningless," according to Steve Hanke, a currency expert and professor of applied economics at Johns Hopkins University, a Forbes columnist and a senior fellow at the Cato Institute, a libertarian think-tank in Washington, D.C. He was out of the country at the time of an interview request, but responded via e-mail. "What is important is a stable currency. Stability might not be everything, but without stability everything [else] is nothing."

Volatility always

The dollar is, by virtually any standard, the world's currency. According to U.S. Senate testimony Hanke gave earlier this year, 90 percent of internationally traded commodities are invoiced and priced in dollars. The dollar is also on one side of 90 percent of all foreign exchange transactions in the world. At the end of 2001, central banks held dollar reserves of some $1.5 trillion, or about 75 percent of central bank reserves worldwide; 60 percent of the capitalized value of all traded companies in the world are denominated in dollars; and better than half of all dollars in circulation are held outside U.S. borders.

Image: Strong Dollar

*Source: Adapted slightly from
Strong Dollar, Weak Dollar: Foreign Exchange Rates
and the U.S. Economy
, Federal Reserve Bank of Chicago, July 1997

Some of that dominance is the offspring of the prosperity rocket that was the U.S. economy in the 1990s. During this period, the capital needs of U.S. companies grew—they needed money to buy new computers, build new plants, invest in emerging markets—while there was a coincidental plunge in the U.S. personal savings rate. So in order for U.S. companies to grow, financing had to come from elsewhere.

Seeing the high rates of return on investments for U.S. assets in the 1990s—especially compared with other countries—foreign investors were more than happy to fill the void, and the U.S. economy became a capital vacuum. By 2001, net foreign purchases of U.S. securities (corporate and other bonds, corporate stocks and Treasury securities) hit $400 billion, or roughly two-thirds of net savings in foreign countries, according to a September 2002 report on global finance by the International Monetary Fund.

Starting around 1995, when the dollar was relatively weak, growing worldwide demand for dollars fueled its steady, if jagged, climb against other currencies over the next half-dozen years. But during this time, strong-dollar critics were cordoned off to the fringe because the U.S. economy was doing fabulously, thank you, so let's not mess with success.

Although the dollar dropped briefly in March 2001, when the economy officially entered a recession, it has maintained comparatively high value in the face of less-than-stellar conditions over much of the last two years. In March 2002, the dollar peaked at a shade over 133 yen, its highest rate in over a year. Meanwhile, the euro was trading for just 87 cents on the dollar, not far off the record low of 83 cents and well below the "even trade" threshold that most European officials had hoped (indeed, expected) when the euro was launched in 1999.

In the face of widespread manufacturing layoffs nationwide, those who believed that a strong dollar was bad for the U.S. economy started gaining traction and converts. These critics began making their case with the U.S. government to do something. There was a lot of talk, but no action.

Nonetheless, only four short months later in July, the euro reached dollar-parity and has stayed within a few cents of that mark through October. The dollar swooned almost 13 percent to about 116 yen. Now, strong-dollar proponents were the ones pleading for government intervention to bolster the mighty greenback. But while people argued about the pros and cons of this exchange movement, by October the market gave back better than half of the dollar's loss against the yen.

(Indeed, no two countries think alike regarding the preferred strength or weakness of their currency, and governments sometimes engage in foreign exchange, or forex operations—called interventions—meant to alter a currency's value. These operations are often fruitless, for reasons that shall go unexplored here, but the curious reader will find more on this subject in a June 2001 Region article, "Sterilized fx.")

Feel the pain

The dollar's long-term strength and short-term volatility provide a useful framing for the argumentative din over whether a (perceived) strong or weak dollar is good for U.S. business.

Talk to almost any manufacturer, and a strong dollar is tantamount to some flesh-hungry disease, because it eats them alive, making their products more expensive (and thus, less competitive) overseas. A strong dollar also makes imported goods cheaper (and more competitive) in U.S. markets.

Manufacturing makes up 85 percent of U.S. "goods" exports and two-thirds of all exports, according to the National Association of Manufacturers. In May 2002 testimony to a Senate committee, NAM president Jerry Jasinowski said exports had fallen by 20 percent, or $140 billion, over the previous 18 months, shedding a half-million jobs in the process. The American Forest & Paper Association blamed the strong dollar on the fact that the trade deficit in this industry alone rose from $3 billion in 1995 to $13 billion by 2000.

The National Cotton Council said the dollar's strength has implicitly allowed Asian exporters to cut prices by an average of 23 percent since 1997 and pushed up exports to the United States by an "astonishing" 65 percent. At the same time, U.S. profits in this industry "have virtually disappeared"; U.S. textile shipments have declined by 25 percent, or $12 billion; and "a swath of misery has spread across the Southeast," where much of the industry is concentrated. To understate, the dollar's drop this past summer was welcome news to many.

But at the same time, others were bemoaning a weakening dollar. Arthur Laffer, founder and chairman of Laffer Associates, an economic research consulting firm in San Diego, said the strong dollar stems from a pro-growth attitude in the United States, and is the product of complementary policies in key areas such as taxes, trade and monetary policy. These pro-growth policies, in turn, create a good investment environment with high rates of return, which generates strong demand (and thus, exchange value) for the dollar among foreign investors looking for a piece of the action. In contrast, Laffer said, slow-growth, protectionist national policies mean a bad investment environment and poor returns on investment, which pushes capital elsewhere and leads to a weak currency.

Image: Weak Dollar

*Source: Adapted slightly from
Strong Dollar, Weak Dollar: Foreign Exchange Rates
and the U.S. Economy
, Federal Reserve Bank of Chicago, July 1997

"The bottom line is ... a strong dollar reflects a strong economy," Laffer said. "Which would you rather invest in?"

The recent IMF report answers Laffer's rhetorical question. It noted that capital flight to the United States "has been driven by international investors' perception that U.S. financial assets offer superior investment opportunities." It added that investors believed productivity was higher in the United States, that it will continue, and "that the U.S. macroeconomic policy framework has been more conducive to high output growth than the frameworks in place elsewhere." Simply put, the United States looked like a good investment, and it was, outperforming all comers, particularly over longer investment periods.

And so the answer to the question of whether a strong or weak dollar is better for the economy appears to be, well, yes; that is, it's a two-sided answer, with winners and losers on both sides.

1 + 1 (does not always) = 2

Such fickleness ultimately begs a broader question about different exchange rate systems, like floating vs. fixed: whether one might be better than another, or whether one might take some of the wildness out of the roller coaster ride.

The irony is that the world shifted to a floating exchange rate system three decades ago with the expectation that exchange rates would become less—not more—volatile. In a floating system, the dollar's value is determined by the demand placed on it in forex markets—or more specifically, by forex traders buying and selling various currencies to meet the financing needs of global companies and the investment desires of global investors. [Other types of exchange rates include fixed and pegged; see sidebar.]

With the market now in control of exchange rates, advocates believed, the value of a particular currency would be based more predictably on a nation's economic "fundamentals"—things like the balance of trade, productivity, fiscal management and the direction of leading indicators like employment and output. This argument—that economic "fundamentals" determine the exchange rate of the dollar—is trotted out regularly by Wall Street wags when justifying a comparatively high valuation of the dollar.

When the world was taken off the gold standard in the early 1970s (which was a fixed exchange rate system) and put on a floating exchange system, advocates believed that information on fundamentals would establish a clear economic rationale for valuing currencies against one another. Volatility would be prevalent at first, floating advocates conceded, but over time currency rates would be driven by fundamentals. Exchange rate fluctuations would thus become predictable, thereby eliminating the biggest economic cost—namely, risk—to a market-based mechanism for valuing different currencies.

But there are a lot of cracks in that argument. For one, the fundamentals theory has become the critics' whip when the dollar's value gets seemingly out of whack—like this year when the dollar was strong despite a lackluster U.S. economy, where fundamentals would suggest that the dollar was overvalued. NAM's Jasinowski testified that "global financial markets are not serving their natural function of rationalizing exchange rates based on 'fundamental' factors like the strength and stability of various nations' economies."

The reason for such a misalignment is that, simply, the theory doesn't hold water, according to an alternate view.

Image: Economic Fundamentals In essence, currency markets are different from markets for other commodities. To suggest that currency rates should be left to markets to establish an efficient equilibrium is to misapply market theory on an object—fiat currency—that is unlike any other. (Fiat currencies are mediums of exchange that are intrinsically useless, unbacked and costless to produce.) "For fiat currencies, there are no inherent fundamentals that determine equilibrium exchange rates," according to economist Neil Wallace, writing in the Minneapolis Fed's Fall 1979 Quarterly Review ("Why Markets in Foreign Exchange Are Different From Other Markets").

Most economists, given to extolling the virtues of markets in determining economic equilibria, reflexively extend those same virtues to currency markets, but a different logic applies to fiat currencies, Wallace warned. Demands for fiat currencies are determined entirely by speculation. "[O]ne goes badly astray by reasoning about the international monetary system from an analogy between fiat currencies and other objects like apples, oranges, and shares in General Motors," according to Wallace.

The evidence certainly seems to agree. There's no traceable pattern between economic fundamentals and the dollar's value, particularly in the short term. Research by Richard A. Meese and Kenneth Rogoff in 1983 demonstrated that a fundamentals model was less useful for predicting the dollar's future value than a naive model-which means simply that the best forecast of future exchange rates is the current rate. ("Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?" Journal of International Economics, February 1983.)

Others disagree. Fundamentals do determine exchange rates, but only in the big picture, according to Laffer. "Unfortunately, the world is not so clear" regarding the direct effect that different fundamental indicators have on the dollar's value, he said.

In general, fundamentals do affect currency strength, according to Edwin Truman, a senior fellow at the Institute for International Economics, a former assistant secretary for international affairs for the U. S. Treasury and former director for international finance for the Federal Reserve's Board of Governors. Currency values in the short term "can have wide fluctuations for largely inexplicable reasons," Truman acknowledged. But "it's over time" that fundamentals like an economy's productivity and competitiveness, balanced fiscal policy and "sober monetary policy" get reflected in currency valuations.

In other words, economic fundamentals and the dollar's exchange rate tend to align only when the time frames are broad, the economic indicators considered are general, and alignment means being in the same ballpark, not sitting in each other's lap.

But skeptics point out that given such a big target, how can anything miss? Even advocates of the fundamentals approach concede that it can't be easily applied to near-term valuations, because the morass of details and caveats that underlie both economic fundamentals and forex markets create too much noise to predict currency fluctuations in the short term.

For example, one must weigh the risk mentality of investors. After Sept. 11, the dollar dropped only a few percentage points against other major currencies. But it recovered, and then some, when investors looked to the U.S. dollar for safe haven in an unstable economic and political environment worldwide. In 2001—a year spent mostly in recession and compounded by terrorist attacks—foreign investors increased their net dollar holdings by $24 billion to $276 billion, according to the Department of Commerce.

Nor does everyone involved in foreign exchange transactions have the same objective. As an article in The Economist pointed out, forex traders have a much different objective from government policymakers when it comes to exchange rates and currency valuations. "Their job is to make money, or at least not to lose it. Whatever their view of the economic fundamentals, they cannot ignore market trends." In exchange transactions, the dollar is never over- or under-valued. It's always worth exactly what buyers are willing to pay for it.

Change for a dollar?

Once again, the theory that floating exchange rate systems are more efficient might seem intuitive, but the model hasn't performed to people's expectations, and the floating system has some nasty side effects. As discussed earlier, a floating regime implies that the value of the dollar will be based on economic fundamentals, but that has not been the experience. Since the early 1970s, exchange rates have been volatile and unpredictable.

The problem with a floating exchange rate stems not from the up-and-down volatility of how markets set exchange values, per se, but from the uncertainty of volatility. Unpredictable volatility equals risk, the Achilles' heel of any exchange regime because it dampens trading. The launch of the euro is a good example of the desire to eliminate exchange rate uncertainty and risk among countries.

In their 1989 Minneapolis Fed Annual Report essay, Arthur J. Rolnick and Warren E. Weber argued that the floating regime was an unmitigated failure—not only were exchange rates more volatile and unpredictable, but the system also failed to correct economic fluctuations and trade imbalances as advocates promised. This was reason enough to consider going back to a fixed exchange system.

Laffer agreed that a fixed exchanged rate offered some useful advantages, including eliminating the deadweight loss of transaction costs—a dollar today buys the same number of yen tomorrow. "That is a real beneficial effect of not having those transaction costs," Laffer said. But he stopped short of advocating for a change. "If the best monetary system could run it, it'd be great." But a fixed exchange system controlled by ill-equipped and undisciplined countries "will kill you."

Truman, of the Institute for International Economics, acknowledged the warts of today's floating regime, saying it was "a bit like democracy." Although it can lead to pricing and competitiveness problems for manufacturing and other sectors, "it's probably the best. But that doesn't mean it's perfect."

But the jury is still out. At this point the burden of proof lies with the floating exchange rate system, if only because that system is in place. Advocates have argued that the long run will prove their point, but the floating system has been running for quite some time now. How much longer before we know?