Paul Krugman

For US dollar, strength is weakness

US growth has improved lately, yet the state of the economy still leaves a lot to be desired says the writer.
US growth has improved lately, yet the state of the economy still leaves a lot to be desired says the writer.PHOTO: AGENCE FRANCE-PRESSE

We've been warned over and over that the Federal Reserve, in its effort to improve the economy, is "debasing" the dollar.

The archaic word itself tells you a lot about where the people issuing such warnings are coming from. It's an allusion to the ancient practice of replacing pure gold or silver coins with "debased" coins in which the precious-metal content was adulterated with cheaper stuff. Message to the gold bugs and Ayn Rand disciples who dominate the Republican Party: That's not how modern money works.

Still, the Fed's critics keep insisting that easy-money policies will lead to a plunging dollar.

Reality, however, keeps declining to oblige. Far from heading downstairs to debasement, the dollar has soared through the roof. (Sorry.)

Over the past year, it has risen 20 per cent, on average, against other major currencies; it's up 27 per cent against the euro. Hooray for the strong dollar!

Or not. Actually, the strong dollar is bad for America. In an immediate sense, it will weaken our long-delayed economic recovery by widening the trade deficit. In a deeper sense, the message from the dollar's surge is that we're less insulated than many thought from problems overseas. In particular, you should think of the strong dollar/weak euro combination as the way Europe exports its troubles to the rest of the world, America very much included.

Some background: US growth has improved lately, with employment rising at a pace not seen since the Clinton years. Yet the state of the economy still leaves a lot to be desired. In particular, the absence of much evidence for rising wages tells us that the job market is still weak despite the fall in the headline unemployment rate. Meanwhile, the returns America offers investors are ridiculously low by historical standards, with long-term bonds paying only a bit more than 2 per cent interest.

Currency markets, however, always grade countries on a curve. The United States isn't exactly booming, but it looks great compared with Europe, where the present is bad and the future looks worse. Even before the new Greek crisis blew up, Europe was starting to resemble Japan without the social cohesion: Within the euro zone, the working-age population is shrinking, investment is weak and much of the region is flirting with deflation. Markets have responded to those poor prospects by pushing interest rates incredibly low. In fact, many European bonds are now offering negative interest rates.

This remarkable situation makes even those low, low US returns look attractive by comparison. So capital is heading our way, driving the euro down and the dollar up.

Who wins from this market move? Europe: a weaker euro makes European industry more competitive against rivals, boosting both exports and firms that compete with imports, and the effect is to mitigate the euro slump. Who loses? We do, as our industry loses competitiveness, not just in European markets but in countries where our exports compete with theirs. America has been experiencing a modest manufacturing revival in recent years, but that revival will be cut short if the dollar stays this high for long.

In effect, then, Europe is managing to export some of its stagnation to the rest of us. We're not talking about a nefarious plot, about so-called currency wars; it's just the way things work in a global economy with highly mobile capital and market-determined exchange rates.

And the effects may be quite large. If markets believe that Europe's weakness will last a long time, we would expect the euro to fall and the dollar to rise enough to eliminate much if not most of the difference in interest rates, which would mean severely crimping US growth.

One thing that worries me is that I'm not at all sure that policymakers have fully taken the implications of a rising dollar into account. The Fed, still eager to raise interest rates despite low inflation and stagnant wages, seems to me to be too sanguine about the economic drag. And the most recent Fed minutes suggested that some members of the committee that governs monetary policy were thoroughly clueless, apparently believing that inflows of capital would make the US economy stronger, not weaker.

Oh, and one more thing: A lot of businesses around the world have borrowed heavily in dollars, which means that a rising dollar may create a whole new set of debt crises. Just what the global economy needed.

Is there a policy moral to all this? One thing is, it's really important for all of us that Mr Mario Draghi at the European Central Bank and associates succeed in steering Europe away from a deflationary trap; the euro is their currency, but it turns out to be our problem. Mainly, though, this is another reason for the Fed to fight the urge to pretend that the crisis is over. Don't raise rates until you see the whites of inflation's eyes!

NEW YORK TIMES