Although in office less than a fortnight, the new US
Administration is showing a disregard not only for the domestic convention but
international agreements like on refugees and its talk about the dollar.
Some observers had argued that the conduct of monetary policy was tantamount to
currency manipulation, but the G7 and G20 offered a more nuanced
understanding.
Manipulation itself was not frowned upon
because it violated the sanctity of the markets as some moralists want to
argue. Rather manipulating domestic interest rates was
accepted. It is not a zero sum game. Currency manipulation to boost
exports is a zero sum undertaking and is
thought best to avoid.
Over the last couple of weeks, several
Administration officials have talked about the dollar. Some of these
remarks were in the confirmation hearings and needed
to be kept in that context. However, others seem to have gone out of
their way to comment. Trump himself warned a few days before the
inauguration about too strong of a dollar.
Today, the head of Trump’s new National Trade
Council, Peter Navarro, told the Financial Times that the euro was “grossly undervalued.” He warned that euro was like an
“implicit German mark” and its low valuation gave German an advantage
over its trading partners. Navarro said Germany was one of the main
obstacles to a trade deal with the EU. He confirmed what has been
suspected: TTIP, the Transatlantic Trade and Investment Partnership
negotiations, will not be going forward under Trump.
On balance, many of the comments from Trump
officials have expressed concern about the strength of the dollar or, as
Navarro, complained about other currencies being
undervalued. The OECD confirms. Its models see the euro
at nearly 25% undervalued, sterling
almost 16.5% undervalued and the yen 11% under-valued. The Mexican peso,
whose marked depreciation has been exacerbated
by comments by Trump, is undervalued,
according to the OECD, by 147%.
On the other hand, Ted Malloch, who is widely
tipped to be the next US ambassador to the EU(and presently a professor at
Henley Business School at the University of Reading) is a Eurosceptic. He said he wanted to
short the euro and intimated that the eurozone
could collapse in the next 18 months.
It is still the early days of the Trump Administration, and it is not clear whose
opinion will carry the day. Trump, for example, seemed to support
torture to acquire information but
deferred to the Secretary of Defense General Mattis. It is not known whether the comments are one-off
or part of a sustained campaign.
At the same time, we argue that reason
the dollar is strong is not that
European, Japanese, and Mexican officials want a weak currency, though some officials clearly do. Rather
the dollar’s strength is not built on
wishes but the incentive structure created by actual policy. In
particular, the divergence of monetary policy, broadly understood, has been, arguably,
the single biggest force lifting the US dollar.
There is some anticipation of a more
supportive policy mix. Fiscal policy has been neutral to a drag in recent years, but it has been clear
since last summer that regardless of the election outcome US fiscal policy
would be more accommodative. That policy mix of looser fiscal and
tighter monetary policy is associated
with currency appreciation. Looser
fiscal policy includes tax cuts (reform), infrastructure spending, and some
supply-side deregulation. Alone, such fiscal efforts would also likely be
understood by investors as favorable for the dollar.
Looser fiscal and tighter monetary policy was
the policy mix under Reagan-Volcker that led to a dramatic dollar overshoot in
the early 1980s and was the first dollar
rally since the breakdown of Bretton Woods in 1971. It was also the
policy mix in Germany when the Berlin Wall fell. The fiscal laxity needed
to finance the leveraged buyout of East Germany was
offset by the tightening of monetary policy by the Bundesbank. The
Deutschemark overshoot that resulted spurred an ERM crisis that ultimately
paved the way for monetary union.
Another consideration has joined the mix.
The border tax adjustment is seen by many as automatically spurring a
significant dollar appreciation. It is part of a destination-based
corporate tax that is being touted.
It would tax imports and exempt exports. Relying on theory, many
economists expect that the dollar would rise to offset the tax. A 20% tax
would produce a 25% appreciation of the dollar.
The view is
based on economic identities that are true by definition. If
the dollar does not appreciate in full, then the domestic savings must increase
and/or domestic investment must fall,
with the rest of the world moving equally but in the opposite
direction. We are skeptical that a change in goods
prices will automatically drive the dollar. In our understanding of
foreign exchange drivers, we put an emphasis on the market for capital not the
market for goods.
We can understand how a tax on imports can
boost the price of goods that could, in turn,
increase the general price level (inflation). Yet, higher import prices could also sap the purchasing power of US
households and weaken aggregate demand. We can envision how a tax on
imports and exemption for exports can boost some sectors’ profitability and
boost corporate savings.
Jawboning can impact foreign exchange prices,
as we have seen today, with the pop in the euro following Navarro’s comments.
However, over time, we expect policy is the ultimate driver of exchange
rates. Although details about the new Administration’s fiscal policy are
not known, we anticipate a bullish mix and other policies that are broadly
supportive of the dollar. The jawboning will likely soon reach a point of
diminishing returns as has the jousting with Mexico, and as Japanese officials
have also discovered.
It is possible that to offset the strong
dollar policies that President Trump could order an intervention in the foreign exchange market. Since
2008-2009, many observers, media, and some policymakers have argued that the US
(and others) are engaged in currency wars. We demurred. If the US
were to intervene to drive the dollar lower, it would make a mockery of the
earlier cries.
Policymakers did not recall the lesson of the
Great Depression and weakened the financial pipes before the financial crisis.
Policymakers did not recall the lessons of the 1920s about the disparity of
income and wealth and the political blowback
that could result. Policymakers did not recall the limits of a country’s
willingness and ability to service foreign debt from current production.
Policymakers may be forgetting the disastrous consequences of protectionism (taxing imports and exempting
exports) and beggar-thy-neighbor currency policies.