Commentary: Cutting The Deficit Won't Beef Up The Dollar

Nursing a broken thumb, Fed Chairman Alan Greenspan told the assemblage of economists and monetary experts in Jackson Hole, Wyo., on Sept. 1 that it may have been the "consequence of excessive fine-tuning." Indeed, Greenspan got high marks for his monetary twiddling, which has slowed the economy without pitching it off a cliff.

But some top-gun economists at the Federal Reserve Bank of Kansas City annual conference were thumbs-down on Greenspan when it came to the dollar. They challenged his view that cutting the budget deficit could boost the value of the greenback. Laurence Ball of Johns Hopkins University and N. Gregory Mankiw of Harvard University sparked the attack, dubbing as "fallacious" Greenspan's contention that the high deficit is to blame for the weak dollar--and that balancing the budget would send it climbing. Just the opposite is true, they maintain: A lower deficit leads to a lower dollar, and a higher deficit pushes the dollar higher.

RATE BAIT. The Ball-Mankiw argument is strong. Here's the logic behind it: A growing deficit means the government must borrow more, pushing up interest rates. As U.S. interest rates rise relative to the rest of the world's, money flows out of foreign assets and into U.S. securities. This capital flow raises the dollar's value because to buy U.S. securities, foreigners must dump their own currencies and buy dollars.

Conversely, a decreasing deficit lowers government borrowing and thus pushes interest rates down. As rates fall, investors seek higher returns overseas. They sell dollars and buy foreign bonds. The result: a depreciating dollar. "No question about it," agrees Harvard's Martin Feldstein. "Cutting the deficit means a lower dollar."

Greenspan concedes that the Ball-Mankiw makes sense in theory, but he contends that in practice it would be offset by another factor: A cut in the deficit would reduce inflationary expectations, making U.S. assets less risky and more attractive to investors. Foreigners, rather than selling dollars, would be buying them. So the dollar would rise, not fall like the economists were arguing.

Greenspan's case is the weaker one. For one thing, inflationary expectations are largely based on monetary policy. If the Fed is holding a tight grip on the money spigot, inflationary expectations will be dampened--even if the federal deficit rises. Look at Japan: Its deficit has rocketed to a projected 4.1% of gross domestic product this year--more than three times what it was two years ago. That hasn't heightened the risk of holding Japanese bonds, though, because the Japanese have kept money tight. And what of the yen? Even as Japan's deficit has ballooned, it has remained rock-solid.

MYTHICAL POWER. The U.S. experience seems less clear, but it, too, calls into question the Greenspan line of reasoning. During the mid-1980s, as deficits exploded, the dollar soared. And over the past year and a half, the commitment in Congress to balance the budget has intensified, yet the dollar has weakened. Robert Johnson, an economist and trader at Moore Capital Markets, put it this way: "If I'm sure the deficit is coming down, then I short the dollar." Even within the Fed research staff, there is some dispute over whether the boss is right.

If budget-cutting were to lift the dollar, as Greenspan suggests, fiscal discipline would have a devastating effect. Not only would the economy slow because of the cut in government spending, but the higher dollar would cause exports to fall, while imports would take off.

Somehow, a strong dollar makes people feel that all is well with America. So it may be almost natural to associate a robust dollar with a government that is finally balancing its budget. However, it was a strong dollar in the 1980s that almost decimated U.S. industry, pricing its products out of world markets. And it has been the declining dollar that has helped make America competitive again. Thumbs up, then, for budget-cutting and what is likely to follow: a lower dollar.

Senior Editor Zucker directs BUSINESS WEEK's economics and markets coverage.

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