Trumping the dollar

One of the more fascinating developments in the seven months since US President Donald Trump was elected has been the trajectory of the dollar relative to other major currencies. After soaring in the wake of his victory, the dollar’s value began to slide in April.

There are various explanations for this. One is that Trump’s much-anticipated economic-growth agenda has not materialized and stands no chance of making it through Congress. Another is that the rest of the world, not least the euro zone, has performed better than expected since his election.

I spent decades immersed in the intricacies of the foreign-exchange market, so I know it is foolhardy to assume one can ever know everything that is going on. Still, beyond the cyclical explanations for today’s trends, a third explanation has become increasingly clear: Markets have built in a risk premium for the dollar to account for the uncertainties that Trump’s presidency has introduced.

In the course of estimating the underlying equilibrium value of the dollar and other currencies, I have developed a process for approximating where a currency “should” be trading, all things being equal. This process has generally served me well, insofar as anything can serve one in the world of foreign exchange. Assuming it is at least vaguely accurate, we can conclude that any resulting deviation in the actual value of a currency represents a kind of premium or discount.

According to conventional economic theory, the exchange rate can be calculated in terms of a currency’s purchasing power parity (PPP). If the same basket of goods can be purchased with the same number of euros as dollars, the exchange rate is 1:1. But in the early 1990s, I came to regard this approach as insufficient because it failed to take into account that the underlying real (inflation-adjusted) exchange rate could itself vary.

Bela Balassa, Paul Samuelson and John Williamson were among the earliest economists to estimate the real exchange-rate equilibrium that, in a perfect world, also reflects the balance-of-payments and full-employment equilibria.

But when I was at Goldman Sachs I developed my own, very simple version of this framework: The Dynamic Equilibrium (Real) Exchange Rate (GSDEER). Right now, the GSDEER for the euro-dollar exchange rate is around €1:$1.20, which suggests the dollar is overvalued against the euro by 6-7 percent.

I also developed what I call the Adjusted GSDEER, which corrects the “equilibrium” rate for the ongoing economic cycle by accounting for factors such as the real interest-rate differential between the US and the euro zone.

Which interest rate is best for making comparisons is up for debate, as are the effects of quantitative easing, but I see no good reason not to use the 10-year government bond differential, adjusted for inflation expectations.

Accordingly, the Adjusted GSDEER for the euro-dollar exchange rate as of June 7 was €1:$1.0590. Given that the dollar was trading at around $1.1250 against the euro on that day, this suggests the dollar is actually around 6 percent weaker than it should be.

Of course, 6 percent is not a particularly significant difference, and this finding may not mean anything. Those who are bullish on the dollar (and who probably have plenty of underlying biases) would tell you now is an ideal time to buy dollars as the value is sure to rise. They may be right. The US economy could start to grow at a faster rate, Trump might somehow get some of his growth-boosting policies enacted, and Europe’s growth may taper off.

On the other hand, the euro zone could maintain its amazing ascent, and the Trump administration may continue to disappoint. Moreover, Trump’s proposed policy framework might very well deserve to have a rising risk premium. It is still too early to know for sure, given that the stock market continues to reach new heights while US bond yields have softened.

But if the Trump administration does pursue a deliberate policy of isolationism, high-risk premiums on the dollar will have been justified, especially when one accounts for the persistently low US domestic savings rate and high dependency on net foreign capital.

Some economic observers have long believed the US cannot sustain an economy in which personal consumption constitutes 70 percent of gross domestic product (GDP). And for a brief period in 2008-2009, it looked as if the US economy could be on the verge of a major structural adjustment, some of which could have been helpful if it reduced consumer dominance. Fortunately the worst was avoided, but almost a decade later, US domestic consumption once again accounts for more than 70 percent of GDP.

There are good and bad ways to shrink the consumption share of GDP to a more appropriate size. The good way is for the US to import less, export more and increase its domestic savings and investment. The bad way, particularly for American consumers, is for the US to pick fights and retreat from the world. Trump and his advisers would do well to act accordingly.

• Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is honorary professor of economics at Manchester University and former chairman of the British government’s Review on Antimicrobial Resistance.

©Project Syndicate