| Weak Isn't Always Bad |
15 December 2003
|
Falling Dollar Does Not Need to Mean Higher Inflation
The US dollar's two-year long slide brought it into record low territory last week, and the inflationphobes took to the pundit circuit to express their worries. It is amazing how everything causes inflation in their world. The fact is that a falling dollar is not inherently inflationary.
A weak dollar means that it takes more dollars to buy goods and services priced in another currency. At US$1.50 to the pound, a £100 coat costs US$150. If the dollar loses value so that it costs $1.60 to get a pound, that same coat is US$160. The coat is the same and so is the price for someone paying in sterling. The inflationphobes argue that imports become more expensive as the dollar falls (true) which means that American pay more for their imports (wrong, not true, and incorrect).
The impaired logic here demands that Americans continue to purchase imports in the same quantity after the dollar weakens as before it did. In other words, vendor of those fine British coats doesn't suffer a single lost sale because of the higher price -- or as economists would say, demand for those coats is perfectly inelastic. That isn't how the world works -- there are, after all, American coats to buy. Apart from air, there is probably no commodity for which there is perfectly inelastic demand.
The other concern of the worriers is the effect a weaker dollar has on interest rates and the stock market. A weak dollar causes foreign investors to dump US securities. One way to strengthen the dollar is to increase interest rates, but this is usually bad for the stock market. On the other hand, its good for the bond market. So non-American investors aren't necessarily deciding whether to be in the US market but rather whether to hold bonds or stocks.
This worry betrays an American mind set, one that is concerned about return on investment. A great many non-Americans put their money in the country with returns as a secondary consideration. Their primary reason for investing is the security of the US system. They are protecting their principal. They are prepared to accept some currency losses in exchange for having their nest egg safe.
Yes, a weaker dollar is inflationary if the US demand for imports of all kinds is perfectly inelastic, if non-Americans would rather have their all their money in Switzerland and if they only buy stocks rather than bonds. However, recalling the deflation fears of a few months ago, is inflation per se inherently a bad thing? If rising prices are helping restore equilibrium, it is actually a good thing.
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