Scott Sumner  

Yes, a strong dollar matters; but why?

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Giles Wilkes directed me to an interesting Financial Times article on the strong dollar:

In its April forecast for the global economy, IMF statistics suggested that global gross domestic product in nominal US dollar terms would hit $74.5tn this year, a contraction of $2.7tn from 2014. This compares with the $3.3tn US dollar recession in 2009, the steepest since records began in the early 1960s.

The IMF did not update its nominal GDP forecasts for 2015 on Tuesday but its downward revision of global GDP growth coupled with the dollar's continued strength since April suggests a deepening in the likely dollar-denominated GDP contraction. The dollar is up 6.8 per cent against a trade-weighted basket of major currencies this year.

The power of the US dollar as a means of trade payment, store of value and a reserve asset for the world is such that any strengthening in the greenback will be widely felt.

Emerging market countries, for instance, still buy most of their imports in dollars, meaning that the depreciation of their national currencies against the dollar has pushed up the price of imports and damped consumer demand.

I do think that the strong US dollar is having a moderate deflationary impact on the global economy. But I have some doubts about the mechanisms described in this article. I doubt that if it matters very much that imports are priced in dollars, or that the US dollar is "a means of trade payment, store of value and a reserve asset for the world". Nor does it matter that global NGDP is falling by around 3% in dollar terms, as workers in other countries are not paid in dollars. Europe will grow this year, despite sharply lower NGDP measured in dollar terms.

Yes, oil is priced in dollars. But commodity prices are not sticky, so it doesn't matter which currency is used. If the euro falls 20% against the dollar, it makes no difference if oil is priced in dollars, and falls 12%, or priced in euros and rises 8%. Either way, Americans and Europeans pay the exact same price in their local currency. Indeed the strong dollar is one of the reasons why commodity prices have fallen this year.

So why does the strong dollar matter? In a word, China.

Despite the recent tiny devaluation, the Chinese yuan is basically pegged to the dollar. Thus unlike the euro and the yen, the yuan did not depreciate sharply against the dollar. This means the yuan appreciated sharply against the euro, the yen, and most emerging market currencies. And this slowed China's economy. As China's growth rate declined their demand for commodities fell sharply. (This was also due to a switch out of heavy industry and towards services.)

Why am I being so picky? After all, the FT was correct that a strong dollar tends to weaken the global economy. I'm being picky because unless we understand the exact mechanism, then we might end up misjudging the effects of a strong dollar in the future. Suppose that in the year 2026 the dollar again strengthens. But this time China's currency is floating, and does not go along with the dollar. Instead, the yuan weakens along with the euro, the yen and the emerging market currencies. In that case I would not expect a strong dollar to have a deflationary impact on the global economy.

Shorter version of post: Never reason from a price change.

PS. Another possible mechanism is dollar-denominated debts become more burdensome. Yes, they are a sunk cost, and should not affect output. But if emerging market borrowers become less creditworthy, it might impact investment in the EMs.

PPS. I strongly recommend Ramesh Ponnuru's recent article on the Fed.

COMMENTS (8 to date)
TravisV writes:

That Ramesh Ponnuru article is awesome awesome awesome. Particularly at the end!

Rajat writes:

In any case, I thought an exogenous depreciation (for 'emerging market countries') was meant to be expansionary?

John Hall writes:

I like this post for two reasons.

The first reason is that I never really get why anyone brings up the point about oil or commodities being priced in dollars.

The second reason is that I saw an interesting point today that dovetails with your China point. Basically, the argument I saw was that China has opened up it's capital account, but still have fixed exchange rates. Under the Mundell-Fleming model, this should mean that monetary policy is less effective. The authors used proof as that when the PBC lowered rates, there were significant outflows of currency.

marcus nunes writes:

The dollar cycles in and out of fashion!

Scott Sumner writes:

Rajat. Yes, an exogenous depreciation is expansionary. Of course the recent depreciations of EM currencies are endogenous.

John, Yes. To the extent they have opened their capital account (I believe partially?) then the Chinese have less monetary policy flexibility, due to the quasi-fixed rate of exchange for they yuan.

Michael Power writes:

You write: "Europe will grow this year, despite sharply lower NGDP measured in dollar terms." And herein lies the dilemma: to an economist, yes Europe will grow. To a fund manager operating out of a dollar world, the economic size of Europe will decline as measured in the size of its dollar GDP from one year to the next so no it will not grow. Which one is right? I am both an economist and a fund manager living in a dollar world: on balance, I think the latter is right.

ThomasH writes:

Would it not be better to say that the deflationary stance of the Fed is having a deflationary impact on the world economy?

ThomasH writes:

The FT guy seems to be saying that because world nominal GDP measured in USD will go down that is a recession. That is patently absurd. You need to look at the domestic deflators in USD to determine that. It is quite possible for every country on earth to grow at 1% in real terms but if the USD revalues more than n% (n=World GDP/US GDP) in relation to other world currencies, the dollar value of world DGP would fall. That is not a recession.

As DeLong says, why can't we .have a better financial press corps.

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