The High Dollar: President Clinton’s Unaffordable Tax Cut
The Labor Department reported today that the price of non-oil imports rose by 1.1 percent in March. This brings the annual rate of increase in non-oil import prices to 9.6 percent over the last quarter. This should concern people because higher import prices translate into higher consumer prices, leading to a lower standard of living. Non-oil imports are equal to approximately 12 percent of GDP. This means if import prices continue to rise at their recent rate, it will raise inflation and reduce our standard of living by a bit more than 1 percent by the end of the year.
Those wondering why import prices are rising don’t have to look far. Import prices are rising because the dollar is falling. A falling dollar means that it takes more dollars to buy the same number of yen or euros. If Japanese and European producers are charging the same price for their products in their own currencies, then the goods they export to the United States will cost us more dollars. That one is pretty straightforward.
The next question is why is the dollar falling? The answer is that the dollar is falling because it was too high.
That should not sound overly mystical. The reason house prices are plunging now is because they had risen to bubble inflated levels that could not be supported by the fundamentals of supply and demand. Back in the late 90s, the stock market had risen to bubble-inflated levels that could not be supported by the fundamentals of supply and demand. And the high values that the dollar reached in the late 90s and the early part of this decade could not be supported by the fundamentals of supply and demand.
There was a very easy way to recognize that the dollar was over-valued. The country was running an enormous trade deficit. The trade deficit was a very modest and sustainable 1.2 percent of GDP in 1996, before the dollar began to skyrocket. At its peak in 2002 the dollar had risen in real terms by close to 40 percent measured against the currencies of many of our major trading partners.
The high dollar had the benefit of making imports very cheap. When the dollar goes up by 40 percent, it means that each dollar can buy 40 percent more yen and euros, making the prices of Japanese and European goods very cheap for people living in the United States. The high dollar of these years effectively raised living standards in the United States (as long as you were not a worker who had to compete with imports), since we could now get very low cost imports.
But the high dollar was every bit as unsustainable as the stock market and housing bubbles. Since we were buying so many cheap imports, our trade deficit went through the roof, reaching $762 billion (5.7 percent of GDP) at its peak in 2006. The trade deficit in that year was more than three times the size of the widely publicized budget deficit.
The trade deficit is the reason that the dollar is now falling. We are paying more dollars to foreigners to buy imports than they need to buy our exports. This means that there is an excess supply of dollars on world markets, which causes the price of the dollar to fall. That’s all pretty straightforward supply and demand – too many dollars supplied, means a lower price for the dollar.
The lower price of the dollar means higher prices of imports for people in the United States. On the plus side, more expensive imports will lead us to buy more domestically produced goods (the lower dollar also increases exports), which will bring our trade deficit down to a manageable level. At that point, the dollar will stabilize and import prices will stop rising so rapidly.
In short, the lower price of the dollar and the pain caused by higher import prices are part of a necessary adjustment process, just as a tax increase may be necessary when budget deficits get too large. The decision by the Clinton administration to promote a high dollar was equivalent to the Bush tax cuts, in that it allowed for higher living standards for a period of time.
However, in both cases, the benefits could not be sustained. In the case of the Bush tax cuts, higher taxes will be needed at some point to limit the size of the budget deficit. In the case of the Clinton high dollar policy, a lower valued dollar will be necessary to bring the trade deficit down to a sustainable level. The biggest difference in this respect is that the impact of the high dollar was much larger, leading to much greater borrowing than the Bush tax cuts. It is important to set the record straight so that we don’t make the same mistakes again.
I have a simpler explanation for the falling value of the dollar: lack of trust of the dollar, due to blatant widespread corruption encouraged during a period of non-regulation, irresponsible borrowing and flagrant looting of public money.
April 11, 2008 11:22 AM | Reply | Permalink
Well said, it is also due to the lack of responsible tax policy under Bush and the exploding federal deficit under Bush and the Republicans, and the loss of faith in the United States as a country that has the smarts to prosper in the 21st century evidenced by our 'election' of the likes of George W. Bush in 2000 and 2004.
April 11, 2008 12:09 PM | Reply | Permalink
any tax cut for the middle class results in more money in the economy, plain and simple. Add to that the fact that those revenues will be withdrawn from a futile war effort and redirected to infrastructure and clean energy development within the states and we "might" have a chance to recover.
we are fubar on the dollar and energy. Europe is fast approaching 20% on renewable energy...a mandate the Republicans refused to adopt for 20 years of rule.
ultimately, without a "standard" for our currency (another PLANNED event from the neo-con agenda) our dollar will remain volitile and weakening to the point of no return.
April 11, 2008 11:49 AM | Reply | Permalink
The trade deficit is the reason that the dollar is now falling.
Nonsense.
The dollar is falling because investors' demand for dollar denominated assets has diminished over the past several years. Why that should have been the case is sheer speculation.
April 11, 2008 11:56 AM | Reply | Permalink
So, let's speculate ---
Over the last seven months -- that is from the start of the so-called "credit crunch" -- the dollar's down against the Euro by 16%.
How come?
Say you're a regional bank in Germany with investments in dollar denominated RMBS. The regulators are looking over your shoulder and starting to mouth-breathe heavily. So, you sell these mortgage-backs and receive your dollars in exchange. But what do you do with them?
I know; let's sell 'em and buy Euros to invest in German Bunds. Nothing safer. Whooh; boy, I feel better already.
April 11, 2008 1:59 PM | Reply | Permalink
Dean,
Pretty simplistic answer for what you know to be a very complex situation. The dollar rose in the late 90's based on fiscal reform that Clinton pushed through, that rubin managed. It was a confidence that the US among the west had finally discovered that we needed to pay down the debt. The markets of Western Europe with its inherent uncompetiveness paled in comparision. Yes, the Euro was just getting started and that caused some upset there. However, tight fiscal policy, increased taxes, and job growth are the formula that led to the higher dollar.
Your treating the situation here, as well, in isolation from the rest of the world which again isn't logical. As started ratcheting up the deficit with GWB the rest of the world saw this and the confidence deflated from this market. Add to this our penchant for throwing people out of work on a whim as business people and you have the current disaster.
The Dollar was no more artificially high then as it is artificially low. It rides the waves of the economy. The whole point is that leadership from Washington on the economy is paramount in being able to ride those waves. No logical person is going to argue that that leadership has been here since Bill Clinton left office.
I don't think you give that administration enough credit for the job done and punish this current administration for the poor job. There was a time after we saved Mexico from a credit default that that economy with our help would be able to grow and sustain its population without it exiting north. We now know what the lack of Leadership in Washington caused to happen these last 8 years.....
April 11, 2008 12:04 PM | Reply | Permalink
The dollar rose because you needed dollars to invest in the DOT-COM stockmarket bubble. Some reform.
April 11, 2008 12:14 PM | Reply | Permalink
Nothing is that simple. If it was we could cure the current problem easily. Even a toady like GWB could get it done..but its a lot more complicated than that.
April 11, 2008 12:29 PM | Reply | Permalink
Dean, Clinton didn't cut taxes, he raised them in 1993 without a single Republican vote. The world helped support the US dollar because America and it's government under Clinton had their respect and confidence as a safe country and a safe currency to save and hold.
Dean, you often have a twisted way of looking at things, and a Republican like trait of blaming the lower dollar, the housing crunch and most of our economic troubles on Clinton or anything or anyone but the guy who has been President for almost eight years, George W. Bush.
April 11, 2008 12:18 PM | Reply | Permalink
NobleCommentDecider,
the dollar actually fell for the three years immediately following Clinton's tax increases. That was the predicted and intended effect. The story was that a high budget deficit led to high interest rates which raised the value of the dollar. (Hence the strong dollar in the mid-80s when the budget deficit soared.) One of the benefits of a lower budget deficit was supposed to be a lower trade deficit, which we were supposed to get via a lower dollar.
That was exactly the story from the people in the Clinton administration at the time.
April 11, 2008 1:20 PM | Reply | Permalink
The story was that a high budget deficit led to high interest rates which raised the value of the dollar.
Big deficits lead to a strong currency?? The dollars fall now has nothing to do with Bush? Oh, it was due to a Clinton 'tax' (Republican framing word).
If I want to hear Republican claptrap I'll tune into Grover Norquist.
April 11, 2008 3:16 PM | Reply | Permalink
. . . Clinton didn't cut taxes, he raised them . . . .
And that's what you get when you vote Republican Lite -- Wall Street enablers.
Bring me your tired, your poor, your huddled dollars yearning to be free -- and I'll gear them at 30 to 1 and make a fortune.
April 11, 2008 1:29 PM | Reply | Permalink
I'm glad to see that I got people's juices flowing. Maybe the folks here invest their money based on how much they like the president. I invest my money where I expect to see the best return (subject to certain other conditions) and I suspect that is true of most investors.
But, that aside, let's try some arithmetic. The trade deficit does depend on the value of the dollar. The higher the dollar, the higher the trade deficit, other things equal. [This is almost an accounting identity.]
If we have a higher trade deficit, then we need more foreign holders of dollars to decide to keep their money in the U.S. than if we had a lower trade deficit. This means that if all foreign investors had the exact some amount of confidence in President Bush's economic policies (or wit and charm) as they did in President Clinton's then we would see a decline in the dollar because of the higher trade deficit, which has resulted from a high dollar.
In order to keep the dollar from falling, we would need to make foreign investors ever more confident in the U.S. economy. Maybe if we could find some foreign investors who never heard about the stock bubble, Enron, SIVs etc, and who wouldn't very good at arithmetic, this would be possible, but I'm afraid such people don't exist on this planet.
April 11, 2008 12:35 PM | Reply | Permalink
I think what you are saying is that high trade deficits can lead to a strong dollar because the Treasury has to pay foreign investors a higher interest rate - Investors must pay for the high yield US bonds in US currency - and essentially that is the 'balance of payments' that allows US to essentially trade debt for goods.
Hence the connection between high interest rates of the 1980's and a strong dollar...right?
But now the world has a competitive 'safe' currency in the EURO - we didn't have that in the '90's.
April 11, 2008 6:35 PM | Reply | Permalink
Exactly, not a concept Mr. Baker seems to understand, this also explains the why dollars are going into gold and commodities. Holders of dollars believe it will not keep value, that debts will be paid off in inflated dollars.
Dean-do you see any connection between the falling dollar and any policies or actions of the Bush administration?
April 11, 2008 10:28 PM | Reply | Permalink
Mr. Baker?? Nothing comes to your mind on this...Bush not to blame, at all??
Dean Baker seems comfortable blaming our economic mess on Clinton or anyone but the current President.
April 12, 2008 12:31 AM | Reply | Permalink
I guess I'm the poor person around here, having no investments to speak of, but I see a lot of pain among people I know and don't want to think of it as a necessary correction. People who live far from urban centers because they can't afford the rent closer to work are having to decide between gas and food--not whether or not to buy the latest WalMart widget. And two men just knocked on my door looking for work.
April 11, 2008 1:41 PM | Reply | Permalink
So ---
Strong dollar = cheaper gas and food; weak dollar = more jobs.
Which do you want?
April 11, 2008 2:17 PM | Reply | Permalink
"..there is an excess supply of dollars on world markets, which causes the price of the dollar to fall."
Why is there an excess of $$? Has the instability of US financial institutions, including our Nation's inability to guarantee the long term value of its bonds have anything to do with the problem. No one's talking about the growing trend of offshore buyers to avoid and even liquidate their US Treasury instruments by expanding the global growth portions of their portfolios.
We've had massive trade imbalances in the past AND a strong dollar. My guess is you're missing the real point...perhaps to make a political point.
April 11, 2008 3:02 PM | Reply | Permalink
Nastywolf,
actually we have never had trade deficits anywhere near as large, relative to the size of the economy, as what we have seen since the late 90s.
The one prior time where the deficits got large (about half as large) was in the mid-80s. This was also driven by a run-up in the value of the dollar, which was at least partially attributable to Reagan's record budget deficits. Of course, the dollar did fall in the years 1986-89 and the trade deficit fell to a more manageable level.
April 11, 2008 3:18 PM | Reply | Permalink
I wonder how you see the issue of the yuan peg to the dollar.
First of all, no American policy caused the Chinese to adopt a peg. Do you agree?
It seems to me that the Chinese currency being undervalued wrt the dollar was a larger contributor to the loss of American manufacturing than the value of any other currency. And that was a huge part of the run up in the deficit.
Compared to other currencies, esp the Euro, the yuan has barely budged. Comments? Prognosis?
April 11, 2008 4:39 PM | Reply | Permalink
Good point. It's not all about some kind of classical supply and demand model. You've got a government intervening in a huge way.
I read that China has something like 3 trillion in US reserves now - that's not a 'balance of payments' that can be sustained indefinitely.
April 11, 2008 6:38 PM | Reply | Permalink
NobleCommentDecider,
In standard economic theory, big budget deficits lead to a high value for the currency. I'm sorry, that's true no matter how much you might like Bill Clinton.
April 11, 2008 7:39 PM | Reply | Permalink
Of course, one man's "big" is another man's "small" and around and around and around we go.
April 11, 2008 9:32 PM | Reply | Permalink
Maybe 'standard economic theory' as assumed at the Dean Baker School, but other schools believe that deficits lead to inflation,i.e. printing money to pay off debts that cannot be paid without debasing the currency.
There is the law of supply and demand, the US dollar has even fallen against the new Iraqi dinar and the Syrian currency, perhaps because we have been flying dollars by the planeload into Iraq.
No matter how much you don't like Bill Clinton, he kept the US government debt under control which was a big reason the dollar held up in spite of trade deficits.
April 11, 2008 10:20 PM | Reply | Permalink
Yep, NobleCommentDecider,
budget deficits lead to higher interest rates and a higher dollar at the "Dean Baker School" just like every other economic school, including the ones where Bill Clinton's economic advisers went to school and/or teach. I suppose the creationist economists might think otherwise, but that's about it.
April 11, 2008 10:40 PM | Reply | Permalink
Dissent,
we actually made a policy decision to acquiesce in the Chinese peg. Just as China is free to set the yuan at a low value relative to the dollar, the U.S. is free to set a peg of the yuan at a high value relative to the dollar.
The politicians who support a high dollar like to pretend that there is nothing we can do other than threaten or cajole the Chinese, but actually the United States is not the weakest country on earth.
Treasury could announce a new policy, beginning tomorrow, that it will exchange a dollars at the rate of 6 yuan to the dollar. Guess what the world exchange rate for the yuan will be then?
Anyhow, it was a policy decision to allow China to keep a low peg of its currency against the dollar -- and a very bad one in my book.
April 11, 2008 7:43 PM | Reply | Permalink
Serious Question.
Where would the U.S. Treasury get the yuan (RMB) to sell? and if it did, who other than a few folks in Hong Kong and Macao would want to buy it?
April 11, 2008 9:11 PM | Reply | Permalink
Re: People who live far from urban centers because they can't afford the rent closer to work are having to decide between gas and food--
I have trouble buying that very many people are REALLY in that situation. You can always find housing moderately close (say, 10-15 miles) to work: However you may find that housing (and if you're a parent, the schools) unacceptable. That's a choice: people have accepted that trade-off deliberately. There is, I will allow, a second problem though: work tends not to stay put. Either people change jobs (and often they are forced to), or else their workplace packs up and moves. I've been through three office moves, mercifully none greatly more distant (and one was actually closer). My sister's factory though was once two miles from her home-- then relocated in the next county, giving her a twenty-some mile commute. Now, she could afford to live up there (housing costs are about the same) but she is not willing to uproot herself and move.
April 11, 2008 6:48 PM | Reply | Permalink
NobleCommentDecider,
In standard economic theory, big budget deficits lead to a high value for the currency. I'm sorry, that's true no matter how much you might like Bill Clinton.
April 11, 2008 7:36 PM | Reply | Permalink
In standard economic theory, big budget deficits lead to a high value for the currency.
Since federal deficits have been increasing since Bush took over in 2001, and the dollar has been simultaneously dropping link
I guess 'standard economic theory' needs some alterations Dean!
April 12, 2008 12:25 AM | Reply | Permalink
Ellen,
The U.S. government is BUYING yuan, not selling them. That's the whole point, it would be driving up the value of the yuan. We have plenty of dollars.
btw, I use "big" deficits in a systematic way -- shares of GDP. They were big in the 80s, fell in the 90s (eventually becoming surpluses) and then rose again under Bush II, but nowhere near as high as in the reagan years.
April 11, 2008 10:37 PM | Reply | Permalink
Point taken.
So, who has yuan to sell to the U.S. Treasury? The Chinese pay for their imports in dollars and euros earned on the export side, yes?
April 11, 2008 11:06 PM | Reply | Permalink
The deal would be that the Chinese would suddenly have enormous incentive to try to evade the official government exchange rate. If they could instantly get 30 percent more dollars for their yuan by getting it out of the country, then you would likely create an enormous black market for yuan.
Needless to say, Chinese businesses would undoubtedly find clever ways to get large amounts of currency out of the country where they could take advantage of the better exchange rate. Meanwhile the Chinese central bank would be accumulating ever more enormous amounts of dollars that for which it had overpaid.
For practical purposes, the exchange rate would probably drift upward to the U.S. official rate. At some point, the Chinese central bank would likely abandon its policy of under-valuing the yuan. Presumably this all could be negotiated to be a more orderly arrangement, but if China insisted on pursuing a policy of under-valuation, it would end up costing them an awful lot of money .
April 11, 2008 11:27 PM | Reply | Permalink
I dunno. Keeping one's head on one's shoulders (and in China that ain't a metaphor) can be a pretty strong countervailing incentive.
April 12, 2008 12:14 AM | Reply | Permalink
Just the woman I'm looking for. I've got a quick OT question... do you happen to know if the Chinese pay tax back to us, on the interest earned from the bonds they own?
September 11, 2008 2:59 PM | Reply | Permalink
Just the woman I'm looking for. I've got a quick OT question... do you happen to know if the Chinese pay tax back to us, on the interest earned from the bonds they own?
September 11, 2008 3:03 PM | Reply | Permalink
NCD,
Let's try this again, the dollar has to fall. We have a huge and unsustainable trade deficit BECAUSE of the high dollar. If the dollar did not fall, the trade deficit would have just kept growing larger as would our ratio of foreign debt to GDP. It is not bad that the dollar falls, it is essential.
Do you want me to give credit to Bush for the dollar falling?
April 12, 2008 7:42 AM | Reply | Permalink
Dean, your analysis is at an undergraduate level of sophistication. Literally sophomoric.
First, a higher dollar does not, as you claim, automatically mean larger trade deficits. It would, ceteris paribus, but other factors are in play, as they always are in the real world.
For one thing, a higher dollar means it takes fewer dollars to buy the same imports. For another, there is much more to capital flows than flows of manufactured goods. For another, the relative attractiveness of one county's investment vehicles vs another's drives the flow of money. For another, governments can and do make deals with each other and direct the actions of their central banks.
For another, changes in monetary policy by the world's largest economy -- Europe -- do, believe it or not, affect currency values and trade deficits of the world's second-largest economy, the U.S. To discuss the dollar and trade deficits without mentioning the creation of the euro is to leave out a crucial piece of the puzzle.
In standard economic theory, big budget deficits lead to a high value for the currency.
So, evidently, do small budget deficits. We saw a high value for the dollar under big Reagan deficits and small Clinton ones.
In short, your analysis is such a tissue of defects that one cannot even begin to address it. Try again.
April 13, 2008 4:52 AM | Reply | Permalink
The single greatest factor controlling the value of the dollar are the interest rates. Since 2002, the interest rates have been cut down drastically, therefore killing the value of the dollar. At one point the interest rates were down to 1%. They have been consistantly at 2%, still extremely low. That is the reason the value of the dollar has been dropping. Foreign investors in the dollar aren't getting good returns because of the low interest rates, so they are dumping the dollar, further reducing the value of the dollar because there is a smaller demand. Simply look at the british pound and the Euro. Back when interest rates were higher, 1 US dollar bought 1.22 Euros. Interest rates were drastically cut in the US to promote the economy and meanwhile, interest rates were risen in the Eurozone, up to 4.25%. Now 1 US dollar only buys .62 Euros. It's simple economics. The interst rate in England is 5.25 %, and 1 US dollar only buys .5 british pounds. Sure, the trade deficite plays a role in the value of the dollar, but it is miniscule in comparison to the effects of the interest rates. If the current administration would put pressure on the Fed. Reserve to raise interest rates to 5%, the value of the dollar would sky rocket, even surpassing the Euro again within a couple of months. The set back would be a slowing down of the economy because it would make it harder for people to get loans, and therefore harder to do business. However, it would definitely bring down inflation, making goods as cheap as they were 10 years ago, and probably reduce gas prices by at least 30% or more.
August 3, 2008 1:18 PM | Reply | Permalink