The dollar will fall – apart from when it rises

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Is the dollar overvalued or undervalued – will it rise or fall this year? The dollar will continue its bumpy ride, but the fundamental reasons why the trend is downward remain in place.

The future of the dollar seems today to be the most important issue for the world economy in 2005. Is it overvalued or undervalued? Will it rise or will it fall? As you would expect any economist to tell you, it is both overvalued and undervalued, and it will go up and down.

The value of any currency is what it will buy. Purchasing power parity holds that a dollar has the same command over goods and services as the euros you could buy with that dollar. Purchasing power parity works well in explaining long-run currency movements and, over a decade or more, changes in exchange rates are mostly attributable to differences in inflation rates. But purchasing power parity is only a preliminary guide.

One problem is that people buy different goods in different countries. A good rule of thumb is that the dollar is cheap when a German can obtain sauerkraut and lederhosen more cheaply in New York than in Munich and expensive when an American can buy hamburgers and plaid pants more cheaply in Paris than in Chicago. On that criterion, the dollar was slightly expensive in 2001 and is today slightly cheap.

Purchasing power parity works because the prices of goods that are imported and exported tend to equalise across frontiers. Globalisation and outsourcing have made more goods and services tradeable than ever before. Fifty years ago there was little international trade in cars and hardly any – or no – cross-border sale of beer, electricity, legal services and advice on how to reboot your computer.

But globalisation can only go so far. Ready-mixed concrete, haircuts and street cleaning are necessarily produced where they are consumed. So exchange rates can show sustained differences from purchasing power parity: the Australian and New Zealand dollars have always looked cheap, the Japanese yen and the Swiss franc have always seemed expensive. Poorer countries tend to have exchange rates below purchasing power parity, which is one reason why tourism tends to flow from rich countries to poor.

But currencies are a store of value and a unit of account as well as a medium of exchange. Dollar assets are popular because people trade in dollars even if they are not buying or selling American goods. And dollar assets are popular because people have been optimistic, even irrationally exuberant, about growth prospects for the US economy.

For years, this demand for dollars as assets enabled the US to run a trade deficit and still maintain an exchange rate broadly consistent with purchasing power parity. But there are limits to foreign demand for American assets, and they have been reached. Today, the only class of investors making net additions to their dollar balances are Asian central banks. Not because they love to see their vaults stuffed with US government securities, but because the only way they can sustain their own very competitive exchange rates is to keep selling their own currency for the dollars that Americans use to buy their exports.

The recent fall in the value of the dollar increases the demand for American goods, but not necessarily the demand for dollars, either as an asset or as a medium of exchange. Devaluation can reduce a trade deficit only if it is accompanied by lower demand for goods and services. But private consumption and government spending in the US continue to grow and there is no intention of adopting policies that will change it.

And so the dollar can be undervalued as a medium of exchange and overvalued as an asset. Does that mean it will go up or down? Short-term currency forecasting is a mug’s game. It is played mostly by people who believe, usually contrary to most evidence, that they are good at it: by “noise traders” who base their decisions not on assessments of fundamental asset values but on trends, momentum, charts and gut feel.

Since the stock market bubble burst in 2000, a stage army of investors has moved from one asset class to another in search of the easy returns once available on stocks – often generating these returns, in the short term, by the scale of their own activities. This movement will probably burn itself out. The dollar’s ride will be a bumpy one but the fundamental reasons why the trend is downward remain in place.

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