Devaluing the Dollar

“‘Devaluing’ [the dollar], of course, is a scary word, but what it really means is American exports become cheaper, and that’s important,” said Sen. J.D. Vance (R-Ohio), one of Trump’s most steadfast allies in the Senate. “If you want to employ a lot of people in manufacturing, you need to make it easier for us to export and not just import what we need.” (Politico)

Economic advisers close to former President Donald Trump are actively debating ways to devalue the U.S. dollar if he’s elected to a second term — a dramatic move that could boost U.S. exports but also reignite inflation and threaten the dollar’s position as the world’s dominant currency. (Politico)

This sounds as if they believe we are still living in a world of fixed exchange rates. We are not. The value of the dollar in international exchange is determined on the market, not by the president.

I see three possible explanations:

1. They don't know that, which seems unlikely.

2. They know that, assume voters don't.

3. They are talking about policies whose result would be to lower the value of the dollar in international exchange.

The third is the interesting one.

I have not found any statement from either Trump or Vance explaining what they propose but there are several possibilities.

To Devalue the Dollar

The simplest way to make dollars worth less is to inflate the currency, print more dollars. While that lowers the value of the dollar in international trade it does not make our goods more attractive to foreigners — they get more dollars for their Euros but need more dollars to buy our goods, since prices have gone up. So it does not reduce the trade deficit or provide jobs for people in export or import-competing industries, which is what Trump and Vance want.

But suppose that instead of spending the money on new government programs or dropping it out of helicopters, you use it to buy and hold Euros.¹ You have increased the supply of dollars and the demand for Euros, so the price of dollars goes down — Europeans get more dollars for their Euros, making American goods cheaper to them. Americans get fewer Euros for their dollars, making imports more expensive for them. The inflation as the dollars come back to buy US exports still happens but now US prices go up by (say) ten percent, the exchange rate goes down by (say) fifteen percent due to the combined effect of the inflation and the government’s currency transaction, so we export more, import less, and the trade deficit goes down. The same logic works if you get dollars not by printing them but by raising taxes or cutting expenditure.

What if you borrow the dollars, sell US bonds? If you sell them to foreigners they will need dollars to buy them with, increasing the demand for dollars on the currency market and cancelling out the effect of the dollars the government is selling. If you borrow them from Americans that doesn’t happen. Raising taxes, cutting expenditure, or increasing the deficit will have a variety of other effects, some of which might affect the exchange rate, but those are complications I am ignoring.

So there are policies the government could follow that would lower the value of the dollar, increase exports, decrease imports, decrease the trade deficit — the result Trump and Vance want. They are, however, expensive policies, since they amount to the government spending money to accumulate a stack of Euros. The current trade deficit is about a trillion dollars a year; to have any significant effect on it will require an expenditure of a substantial fraction of that. Federal revenue is about four trillion, so that means increasing federal expenditures by ten or twenty percent.

We are accumulating assets, a room in the Treasury full of foreign currency, more plausibly interest bearing foreign assets. If we ever stop accumulating them the effect on the exchange rate stops and the trade deficit goes back to its old level. If we spend the currency or sell the assets the effect will reverse, making exports more expensive to foreigners, imports cheaper to Americans, pushing the trade deficit above its original level.

If we want to spend hundreds of billions of dollars a year to provide jobs for auto workers, there is a simpler way of doing it with the same underlying logic. Instead of buying Euros and piling them up in the treasury buy cars and park them, permanently, in the Mojave desert.

Another Way of Putting It

Consider the explanation of the economics of trade in an earlier post. The number of dollars bought with foreign currency equals the number sold for foreign currency. If all dollars bought were bought by foreigners to purchase US exports and all dollars sold were sold by Americans for foreign currency to buy imports, the dollar value of total imports would equal that of total exports and there would be no trade deficit.

The reason there can be a trade deficit is that some dollars are spent to buy assets that stay in the country rather than exports that leave it.² Foreigners are selling us more goods than they are buying from us and using the extra dollars to buy US assets: shares of stock, government bonds, real estate. If the US government buys foreign currency that is the opposite, a capital outflow — we are acquiring claims against foreign assets. If we do it with money taxed or borrowed from Americans that reduces the net capital inflow, hence the trade deficit. If we do it with dollars borrowed from foreigners, sell them government bonds, that is a capital inflow which just cancels the outflow, leaving the deficit unchanged.

Back to the Past

I started by mentioning that we no longer have a system of fixed exchange rates. Back when we did, this is essentially how it worked. The US set the exchange rate on the dollar/Euro market at (say) one Euro per dollar and offered to buy or sell dollars for Euros at that rate. If, at that rate, foreigners wanted to buy more dollars than Americans wanted to sell, a trade surplus, the government would make up the difference, accumulating Euros as a result. If it went the other way, a trade deficit, the government would sell Euros. Eventually, if it ran out of Euros or accumulated too many because the official exchange rate undervalued or overvalued the dollar, it would change the rate, devalue or revalue the dollar.

Alternatively it could change the demand or supply of dollars by raising or lowering tariffs — my earlier post explained how that changed the market exchange rate. One of the arguments for abandoning fixed exchange rates in favor of the modern system of floating exchange rates was that the old system encouraged countries to restrict trade in order to avoid admitting that their money was not worth as much as they claimed.

Another Way to Devalue the Dollar

Looking at the issue in terms of capital flows suggests an alternative approach to devaluing the dollar: Reduce the budget deficit. For foreigners to lend us money they have to buy dollars, pushing the exchange rate, the price of the dollar in foreign currency, up, so the less we borrow from foreigners the lower the exchange rate. Currently about a third of the national debt is held by foreigners. If that proportion holds for new debt as well, each three dollars by which we reduce the budget deficit should reduce the trade deficit by one dollar.³

That understates the effect. Reducing the amount the government borrows from Americans frees up American capital. If it is invested in American assets that reduces the demand for foreign capital. If it is invested in foreign assets it is a capital outflow, an increase in dollars sold for Euros. Either decreases the trade deficit.

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1. More plausibly to buy and hold foreign interest bearing assets, but that complicates the discussion without changing the essential logic. There is no particular reason why it has to be Euros instead of Yen or RMB but that again complicates the presentation without changing anything important.

2. I am including in imports expenditures by American tourists for things such as meals and lodging consumed abroad.

3. I am again looking only at direct effects. Reducing the amount the government borrows from Americans should reduce US interest rates, which should reduce the amount that foreigners invest in other assets as well.