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FRBSF

WEEKLY LETTER

October 7, 1988

Must the Dollar Fall?
The recent strength of the dollar has again raised
doubts aboutthe outlook for the u.s. balance-ofpayments deficit and the future value of the dollar. Many are concerned that the present and
prospective U.S. payment deficits are unsustainable in the long run. To reduce the trade deficit
to a "sustainable" level, they argue, either major
industrial countries will have to make drastic adjustments in their macroeconomic policies or the
dollar will have to fall sharply.
Some also worry that as the dollar declines, u.s.
interest rates will have to rise in order to induce
foreigners to keep holding and accumulating dollar assets. Given the pivotal role of interest rates
in investment decisions, a sharp fall of the dollar
could trigger another stock market crash and
plunge the economy into recession, they fear.
This Letter disputes the basis for such pessimism.
Those who claim that the dollar must fall fail to
take into account the dollar's unique role in
world finance. Given the growing demand for
dollar assets, there is no reason to assume the
dollar must fall.
But to dispute the claim that the dollar must fall
is not to assert that the dollar wi/I not fall.
The former is a question of logic, and the latter
involves a prediction. Nonetheless, predictions
based on faulty logic are not reliable, and business and government policy decisions based on
such predictions could be in serious error.

u.s. payment deficits
Dollar exchange rates are determined by the
demand for and the supply of dollar assets. The
dollar rises when foreign demand for dollar
assets exceeds the supply of dollar assets;
conversely, it falls when the supply of dollar
assets exceeds foreigners' demand.
The supply of dollar assets is closely related to
our trade with foreigners. When we buy more
goods and services from foreigners than we sell
to them, we as a nation offer in payment dollar
assets in the form of u.s. bank drafts, corporate

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stocks and bonds, government securities, industrial and commercial properties, or other kinds of
financial claims on the u.s. economy. When we
run a trade deficit year after year, the stock of
dollar assets held by foreigners rises steadily.
The U.s. payment balance deteriorated sharply
in the 1980s. Compared to an annual average
deficit of only $0.4 billion in the 1970s and an
average surplus of $4 billion a year in 1980 and
1981, it worsened sharply in 1983 and reached
$154 billion by 1987. After three years of steep
dollar depreciation, the payment deficit finally
improved to a seasonally adjusted annual rate of
$140 billion in the first half of 1988. Then the
dollar rose during the summer, dampening hopes
of further balance of payments improvements. In
fact, even before the dollar's recent rise, most
forecasts, which assume that the dollar will
remain at the level attained at the end of 1987,
showed only temporary improvement in the payment balance in 1988 and renewed deterioration
in 1989 and beyond. The Data Resources, Inc.
(DR!) model, for instance, predicted early this
year a u.s. payment deficit of $175 billion in
1990 and of$400 billion by 1995.
The large payment deficits of the 1980s have
meant that foreigners have accumulated dollar.
assets at an exceedingly rapid rate. Foreign holdings of financial assets in the United States more
than tripled from $500 billion at the end of 1980
to $1,540 billion at the end of 1987. Roughly onehalf of the more than $1 trillion increase in U.s.
liabilities to foreigners was offset by u.s. acquisitions of foreign assets. The other half, however, is
associated with the cumulative U.s. payment deficits that arose during this period.
A common fear has been that this rate of dollar
asset accumulation cannot be sustained in the
long run; sooner or later, foreigners' desire for
dollar assets will wane. This means thatthe U.s.
payment deficit must be reduced from its present
level, either through significant changes in major
industrial countries' macroeconomic policies or

FRBSF
through a precipitous decline in the value of the
dollar.

An anchor for the dollar?
This line of thinking has led to the view that the
long-run value of the dollar-absent macroeconomic policy changes-depends on foreigners'
willingness to accumulate dollar assets in the
longrun. The short-run value of the dollar can be
supported by providing attractive interest rate differentials, official exchange market interventions,
or even official pronouncements of intentions to
insure exchange rate stability. But, according to
this view, eventually the dollar must sink to its
long-run sustai nabIe level.
In search of this long-run anchor for the dollar,
three alternative approaches have beensuggested. The first may be called an absolute limit
approach. It is based on the idea that ultimately
foreigners will be so satiated with dollar assets
that they will stop accumulating such assets altogether. At that point, the U.s. payment deficit
must disappear. Hence, the long-run sustainable
value of the dollar, according to this view, is one
that will in time reduce the u.s. payment deficit
to zero.
The second may be called a relative limit approach. It acknowledges that as world wealth
grows, foreigners will continue to add to their
dollar asset holdings. However, foreigners will
not hold more than a proportion of their wealth
in dollar assets. That proportion, coupled with
the growth in world wealth, establishes the limit
on the
ability to finance its payment deficits. Assuming that world wealth grows at the
world real interest rate, simple algebra suggests
that except for interest payments·on the outstanding debt to foreigners, the u.s. payment deficit
must be reduced to zero.

u.s:

The third approach postulates an ability-to-pay
test. Clearly, no country, not even the U.s., can
pay more than a fraction of its income to service
its debt. Proponents of this approach argue that if
the current differential between u.s. and foreign
interest rates implies an expected future rate of
dollar depreciation too slow to bring about significant reductions in future U.S. payment deficits, then the U.s. interest payment on its foreign
debt will continue to rise rapidly. Given reasonable assumptions about u.s. income growth, this

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could imply an ever-rising U.s. debt service-toincome ratio-an obviously unrealistic expectation. According to this view, then, the dollar
must decl ine faster than markets currently
expect.

WiII-o' -the-wisp
Despite their intuitive appeal, these approaches
are fundamentally faulty. All three assume persistent irrationality in the foreign exchange market:
if only the market were cognizant of the long-run
unsustainability of the u.s. payment deficit, the
dollar would fall quickly and sharply. Admittedly,
the stock market crash last October has shaken
confidence in market rationality. But there is no
theoretical basis nor empirical evidence to suggest that financial markets in general and the
foreign exchange market in particular are persistently irrational.
In addition to this general problem, each approach has its own flaws. The absolute limit
approach does not recognize the unique role of
dollar assets in world finance. Because the dollar
is universally accepted as a means of international payment, dollar assets serve as an international store of value to an extent unmatched by
any other asset. Moreover, the breadth, depth,
and resilience of u.s. financial markets provide
dollar assets a degree of liquidity not available
with other assets. There always will be a large
and growing demand for dollar assets as world
wealth expands.
Although the relative limit approach does recognize a growing demand for dollar assets, it fails
to take into account the accelerating international integration of financial markets. Communications technology has made information
instantly accessible to investors in major cities
around the world. Governments have removed
restrictions on capital flows in one country after
another. Increasingly, foreign investors are diversifying their assets internationally, primarily by
acquiring dollar assets. Until this process of international financial integration is completed and
financial markets are fully integrated worldwide,
the ratio of dollar assets to total world wealth will
continue to rise. Admittedly, in the long run, this
ratio will not rise without limit, but for most business and government policy decisions, it is not
the long run, but the medium run, that counts.

Finally, the ability-to-pay approach relies solely
on adjustments in exchange rates to reduce payment imbalances and ignores all other possible
market adjustments, such as changes in income,
prices, interest rates, consumer preferences, and/
or business investment strategies. Such an approach depends on current conditions to stay
unchanged indefinitely and therefore, is not
likely to be a reliable forecast. It is this type of
analysis that led theorists in the early 19th century to predict perpetual world poverty and in
the mid-1970s to forecast world hunger and exhaustion of world petroleum and other natural
resources. Fortunately, the market won, and the
theori sts lost.
In short, the view that the dollar must fall if the
u.s. payment deficit continues to rise is based on
a shaky foundation. It ignores the rising world demand for dollar assets associated with expanding
world wealth and increasing integration of world
financial markets. So long as the U.S. continues
to manage its economy with prudence by preventing runaway inflation, reducing budget deficits, and refraining from imposing foreign trade
and investment restrictions, the U.s. may not face
in the medium run any effective constraints on
the external financing of its payment deficits.

Policy implications
The presence of a large world demand for dollar
assets means a powerful market mechanism at
work to finance U.S. payment deficits, comparable to that which insures the smooth functioning
of inter-regional payment flows and adjustments
within a country. A relatively small rise in U.s.
interest rates in response to strong growth in
domestic demand may be sufficient to ensure external financing of the resultant increase in the
u.s. payment deficit. As world financial markets
become more integrated, the responsiveness of
international capital flows to changes in international interest-rate differentials will increase over
time, making it even easier for the U.S. to finance
its external deficits without drastic adjustments in
its macroeconomic policies.
Whether the demand for dollar assets will indeed
be large enough to meet the supply of dollar assets is an empirical question that the foregoing
analysis cannot answer. However, the recent

strength of the dollar suggests continued strong
demand. Given the rate of growth in world
wealth and the accelerating pace of financial
market integration, it is quite likely that this
demand will grow rapidly enough to support the
expected persistent U.s. payment deficit.
This judgment implies that in the medium run
the persistent U.S. payment deficit is not the
sword of Damocles hanging over the U.S. economy, as is generally thought, but a sword supported by a large cushion of world asset demand.
Consequently, the u.s. monetary authorities
should be able to concentrate on restraining
domestic inflation, free from the gnawing fear
that monetary restraint now might precipitate a
"free fall" of the dollar, soaring U.s. interest
rates, another stock market crash, and a plunge
into recession later.
In the short run, monetary restraint would cause
the dollar to rise and the u.s. payment deficit to
worsen. However, monetary restraint also would
reduce domestic spending and lessen domestic
inflationary pressures, leading to an improvement in the u.s. payment balance. The net outcome of these two influences may be further
deterioration in the u.s. payment balance, but
the magnitude of the net deterioration is not
likely to be significant compared to the growing
world demand for dollar assets.
The bottom-line of all this is that there is no reason to think that the dollar must fall in the face of
continued large and probably rising U.s. payment deficits. Moreover, given the high sensitivity of this demand to relative asset returns, the
monetary authorities of major industrial countries
are in a strong position to maintain dollar stability through coordination of their policies.
However, exchange rate stability combined with
unchanged fiscal policies in the United States
and abroad would mean indefinite world financing of U.S. payment deficits and continued
growth of U.S. debt to foreigners. Whether this
situation is in the long-run interest of both the
United States and the rest of the world is a question pol icymakers must answer.

Hang-Sheng Cheng
Vice President, International Studies

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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