Former Federal Reserve governor Bob McTeer explains why the declining value of the dollar is the "least-worst" way to correct our ongoing trade deficit. The international monetary system is not an easy topic to understand, but he does a good job of making it accessible.

What is the big picture of what's going on with our B/P and the dollar?

Like a family during the process of running up their credit card balances, our large current account deficit means we have been living beyond our means as a country. We have been absorbing (consuming, investing, etc.) more goods and services than we have been producing. This isn't necessarily bad — you can use a credit card for worthy purposes — but it probably was unsustainable and it is the opposite of what one would expect of the world's richest large economy. The "normal" pattern is for capital to flow from rich countries to poor countries, where presumably its return is greater. The reverse has been happening. Capital has moved to the richest country from poorer countries, presumably because our institutions and policies compared to our trading partners more than offset other factors.

What has to happen for "equilibrium" to be reached?

Our exports need to rise relative to our imports. Resources will need to move from other industries into export industries. The declining dollar will provide the needed price incentives by making our imports more expensive at home and our exports less expensive in foreign currencies. Another way of saying that is that the exchange rate will raise the price of traded goods relative to the price of non-traded goods.

Is there an alternative to a declining dollar?

Yes, but they probably would involve more friction and more pain. If the dollar is somehow prevented from falling, the needed adjustments would be the same in terms of exports needing to grow relative to imports, or imports needing to shrink relative to exports. But with no change in the exchange rate, downward pressure on domestic income would push down domestic goods prices relative to international traded goods. Our imports would have to shrink not because of higher import prices, but because of lower domestic incomes. If internal prices and wages were as flexible as the exchange rate, it would make little difference which is used. But internal prices, and especially wages, tend to be sticky in a downward direction, so unemployment would be the likely result. In effect a recession would be needed.

With inflexible exchange rates the temptation would be very strong to avoid the internal adjustments by restricting trade. Our free trade policy would be in jeopardy.

There's lots more. It's not something I'm losing sleep over at the moment, though the falling dollar does make my foreign investments more expensive.

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