Tuesday, 23 May 2017

Articles & Op-Eds

“Strong” and “Weak” Currencies

Posted by
January 10, 2017

Is a “strong dollar” good or bad?  If the currency of another country is pegged to the US dollar, and the US dollar is “strong,” is that good or bad for the other country?

A recent Wall Street Journal article was titled “Heat is on Currencies with Pegs to Dollar” and the subtitle was “The dollar’s climb to multiyear highs is bad news for some currencies pegged to the greenback.”

So, if the “strong dollar” is good, why would that be “bad news” for other countries that peg their currency to the dollar?

Note that the subtitle says bad for countries, not that it is bad for certain people in those countries.  Economics is all about people, so the ‘good’ and ‘bad’ has to be with respect to how individuals are affected by significant changes in exchange rates.

Between any two currencies there is only one exchange rate–which either can be “pegged” by a government, or “floating” in the foreign-exchange market.  Under floating exchange rates, when one currency is “strong” (rising in value) the currency of a trading partner has to be “weak” (falling in value).  In each country the effects of exchange-rate changes are different on their consumers and their producers.

When the US dollar rises relative to currencies of other countries, there are redistributive or “allocative” effects–American consumers of foreign-produced goods see lower prices of imports, but US producers of exported goods see less demand from their foreign customers.  Also, domestic producers that face competition from foreign producers see intensified price competition.

Savers/investors are also affected.  Domestic households and businesses that had previously invested in foreign countries will suffer an “exchange-translation loss” when the dollar rises, while foreigners who had previously invested in the US will enjoy an “exchange-translation gain.”

For the people in countries that peg their currency to the US dollar it is the same as for people in the US–some are positively affected and others are adversely affected.  But, some people in those pegged-currency countries have more political influence than others and may be successful in lobbying for an adjustment in the official exchange rate.  Also, participants in foreign-exchange markets will “speculate” that politicians in some countries will maintain existing pegged rates, while politicians in other countries will cave-in to pressures to “devalue” the exchange rate to a lower pegged rate.

The important point is that there are some who gain and some who lose when exchange rates change–whether as a result of supply and demand in a floating environment or as a result of periodic adjustments in a pegged environment.  As a general principal, a strong and stable currency benefits consumers–changes in prices are a reflection of changes in underlying supply of and demand for goods and services.  However, producers of internationally-traded goods complain to economic policymakers about the adverse effects on them from the price competition of foreign producers resulting from a strong domestic currency.  Long experience around the world has been that producers of goods have more political influence than consumers of goods, so there generally has been a bias against having a “strong” currency.  Sometimes–as has been the case of Japan in recent years–economic policies have the intended objective of weakening the currency relative to that of major trading partners in order to favor domestic producers of tradable goods.

Even when weakening the exchange-value of the currency is not a targeted objective of policymakers, other economic policies–such as anti-business taxation and regulation–can result in “capital flight” as savers/investors seek to move their savings/investments to a more hospitable economic environment.  That certainly has been true in Venezuela in recent years, and probably is a factor in recent weakness of the Chinese currency.  Such countries have current account/trade surpluses, but that is a sign or bad policies and capital flight!

In a fiat currency world with floating exchange rates, there will always be some who are benefiting and some who are not from rising and falling values in currency-exchange markets.  The unavoidable fact is that the “balance of payments” is always balanced!  If an improving business climate–lower taxation and less regulation–attracts both a return of domestic savings and an inflow of foreign investment, the currency will be strong.  The rising capital “surplus” must be matched by a larger current account/trade “deficit.”  The dangers are that politicians will react to such market dynamics in attempts to favor domestic producers of goods at the expense of domestic consumers.

One Comment

  1. Nasu21 January 23, 2017 2:14 PM

    Good job.