A strong dollar no longer suits US interests

One way to help reduce the trade deficit would be to diversify the world's foreign exchange reserves

The US needs to rethink its currency strategy. Our leaders are grudgingly realising that the strong-dollar policy no longer suits either national interests or current economic realities. But the dangers involved in altering the global monetary system mean that transitioning to something new is fraught with peril, and the US needs to move carefully.

For years, the US maintained the official policy that a strong dollar was good for the US and for the world. That probably sounded great to a lot of people for whom the word 'strong' carries positive connotations. But in fact, a strong dollar makes it harder - all else equal - for other countries to buy US-made goods. So a high exchange rate actually makes US exporters weaker in terms of their competitiveness in world markets.

That's why the persistent US trade deficit - which has returned to its all-time high during the Covid pandemic - ought to give policymakers pause when it comes to trumpeting the virtues of a strong dollar:

Stronger dollar, weaker exports

Indeed, US leaders are already making the rhetorical shift. Treasury Secretary Janet Yellen has said she wouldn't seek a weaker dollar, but she also conspicuously fails to extol a strong dollar. The Trump administration had already flirted with the idea of a competitive devaluation of the greenback. And President Joe Biden recently named economist Brad Setser - who has been a strong critic of countries that keep their currencies low against the dollar - to be the counsellor to the US trade representative.

This isn't the first time the US has re-evaluated its strong-dollar policy. In 1985, faced with mounting trade deficits with Germany and Japan, the US negotiated a managed reduction in the dollar's value against those countries' currencies. Following the Plaza Accord, the dollar plunged in value.

Managed values

The agreement had the intended effect, though the trade deficit with Japan shrunk only modestly.

A new Plaza Accord would be difficult. While Germany and Japan are solid US allies, China, the main source of the US trade deficit today, is also the US' main geopolitical rival. Most analysts, including Setser, believe that China is unlikely to accept a large appreciation of the yuan against the dollar. Some Chinese policymakers blame the Plaza Accord for Japan's financial bubble in the 1980s and the subsequent economic stagnation in the 1990s. That's probably wrong - Japan's bubble was due to other factors - but China seems likely to remain wary. So barring a new Plaza Accord with China, how can the dollar be made more competitive? One answer might have to do with the foreign exchange reserves that countries hold. Traditionally, countries around the world hold most of their foreign exchange reserves in dollars. That number has fallen slightly in recent years, from about 66 per cent in 2014 to about 60 per cent today. When foreign countries hold dollar assets, it pushes up the value of the dollar.

So in order to bring the dollar down to a more reasonable level, the shift toward a diversified basket of reserves can and should be accelerated. Other currencies - euros, yen, pounds, Canadian and Australian dollars, and perhaps even the yuan - can join in a global basket of reserve currencies.

One way to encourage this, suggested by Joseph Gagnon of the Peterson Institute for International Economics, would be for the Federal Reserve to start buying up these other currencies. Building up the US' own reserves of other major currencies would push the dollar down a bit, but it would also signal to the world that the dollar is no longer the world's sole reserve currency.

An added benefit of this policy would be to diversify risk in the global financial system. Currently the world is extremely exposed to negative events in one country. If the US were to suffer a period of intensified political violence, it would endanger banks all over the world. Shifting reserves toward a more international mix of currencies reduces this risk.

Ultimately, diversifying the world's exchange reserves won't be enough to correct the yawning US trade deficit - that would require at least a new Plaza Accord with China, and probably a general agreement among countries not to hold down the value of their currencies to prop up exports. But it would be a start. And it would signal once and for all that the era where the US was content to prop up the dollar and see its exports suffer has come to a close. (Bloomberg)