Trump’s dollar confusion

Donald Trump’s most recent tirade that the strength of the dollar is “killing us” would seem to confirm that policy consistency and clear economic thinking are not his strong suits.

Otherwise, how could he be railing against the dollar’s strength while at the same time championing economic policies that make it all but certain that the dollar will continue to rise? Similarly, how can he be berating a country like China for artificially manipulating its currency for competitive advantage, when he is now having the U.S. engage in similar such practices by trying to talk down the dollar?

The world’s long experience with floating exchange rates and open capital markets since the early 1970s should have taught us that verbal foreign exchange market intervention to affect a currency’s value has at best only fleeting results. Indeed, history is replete with failed attempts at such verbal intervention. Rather, by now we should have learned that, absent massive direct intervention in the foreign exchange market, a currency’s value is largely determined by the market’s assessment of the country’s underlying economic fundamentals. We should also have learned that a particularly key factor in determining a country’s exchange rate is the relative level of that country’s interest rates.

At the same time that Trump is trying to talk down the dollar, he is championing two sets of policies that would almost certainly lead to a strengthening of the dollar from its already very high level. The first relates to his proposed budget policy. At a time that the U.S. economy is close to full employment, Trump is calling for major cuts in corporate and household tax rates as well as large increases in defense and infrastructure spending. If implemented, such an expansionary budget policy would almost certainly require the Federal Reserve to raise interest rates at a faster pace than it is currently contemplating. That in turn would cause the gap between U.S. interest rates and those abroad to rise, which would only increase the relative attractiveness of buying dollar assets.

The second set of policies that would likely lead to a strengthening of the dollar relates to trade policy. An essential part of Trump’s program would be to impose tariffs on countries like China and Mexico, as well as to renegotiate trade deals like NAFTA to the advantage of U.S. corporations. He is proposing this at the same time as Republicans in Congress are pushing for a border tax adjustment that would exempt exports from corporate taxes and subject imports to taxes. If adopted, such trade measures would be the equivalent of a dollar depreciation, which must also be expected to increase the dollar’s value in foreign exchange markets.

A clear risk that Trump is running by pouncing on the dollar is that he could be setting himself up for failure and for a loss of policy credibility. If fundamental factors do indeed drive the dollar higher despite his utterances, surely Trump’s policy credibility will be damaged in the markets.

A more serious risk relates to Trump’s likely policy reaction to a further dollar appreciation. Sadly, it is all too likely that should the U.S. dollar continue to appreciate, Trump will double down on his America First policies. He will do so by proposing the imposition of yet more import tariffs on our trade partners and by labeling more countries as currency manipulators. Were he to do so, we must expect retaliation by our trade partners with similar such measure that could very well lead us down the path toward a full-blown trade war. As the experience of the 1930s would amply testify, going down that path would hardly be in the U.S. or global economic interest.

Hopefully, once Trump assumes office he will realize that he has to prioritize his economic policy goals. If he really wants a weaker dollar, he cannot have both an expansionary budget policy and a highly restrictive trade policy. If he does not grasp that reality, we should brace ourselves for some rough sledding in the global economy.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.