Mon, Dec 13, 2004 - Page 9 News List

Don't scapegoat China for a weak dollar and deficit

Rather than blame China for the US trade deficit and the falling US dollar, the finger should be pointed at the US federal reserve's sustained low interest rate policy

By Christopher Lingle

Earth to China-bashers: Beijing should not be blamed for America's trade deficits or the weakness of the US dollar. Those that believe so are confusing symptoms with causes.

Other elements of conventional wisdom have it that there is some choice as to whether the exchange value of the dollar will rise or fall. To this end, the Bush administration has been criticized for a devaluation policy that involves "talking" down the value of the dollar.

At the same time, its penchant for tax cuts is blamed for larger fiscal deficits. But in this case, blame should fall on the Congress for pork-laden spending that is pushing the US government ever deeper into debt.

There is good reason to be concerned with the US trade deficit. It is expected to rise to 6 percent of GDP and hit a record US$600 billion this year, up from US$496.5 billion last year and US$421.7 billion in 2002.

But America's relentlessly wider current account deficit and the decline of the dollar are the result of loose monetary policies of the Fed. In this sense, the dollar's decline was set into motion in the recent past and is an inevitable result of interest rates set so low for so long. Over time, relative increases in money supply set the purchasing power of monies that in turn sets the underlying exchange rate.

And so it is that choices made by Beijing or Tokyo can only have a short-term impact on the dollar. Chinese actions to favor the euro will inspire corrective actions by buyers and sellers to move the dollar back towards the underlying rate of exchange.

Even if China and Japan allow their currencies to appreciate on exchange markets, the dollar's slide will only be slowed temporarily. Such moves will not change the underlying fundamentals that set the relative valuation of global currencies.

This is because a rate of exchange depends upon relative increases in money supply relative to increases in the production of real goods and services. Even if OPEC or China and other countries move away from US assets towards other assets, the dollar would only be weakened temporarily unless there is a change in the underlying rate of exchange.

Misdiagnoses that blame fiscal deficits and trade imbalances for the flagging fortunes of the Yankee dollar encourage another round of policy mistakes.

And they fan the flames of protectionism while also creating unnecessary antagonism between US trading partners that rig their exchange rates in hopes of engineering trade advantages for local exporters.

The simple matter is that the balance of payments does not determine exchange rates. The underlying rate of exchange is set by the relative purchasing power of monies and has nothing to do with the state of the balance of payments. And it is the supply and demand of currencies on foreign exchange markets that determines the relative purchasing power of monies.

Consider that exchange rates are the prices paid whereby one currency is used to purchase another. Currency values are determined by increases in the supply of money relative to how much real output is produced. Just as the purchasing power of goods is determined by supply and demand, so it is for the "price" of money.

With a fixed supply of money, increased production of output means that producers find there are less units of money to cover the increased amount of goods. As such, the purchasing power of money will increase since each currency unit will buy more goods.

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