Global Policy Forum

By Daniel Altman

For many economists, the dollar's jagged yearlong slide is just a side effect of an inevitable contraction in the huge U.S. trade deficit. But current economic and political conditions are making the process more perilous than it might otherwise have been. Recently, the dollar's exchange rates have bounced up and down with news from the Iraq war. But the dollar's overall trend in the last 12 months has been distinctly downward. Weighted by the volumes of trade with other countries and adjusted for inflation, an average of the rates dropped 4.4 percent from March 2002 to last month.

A deeper decline could be on the way, though. The run-up to the war in Iraq hurt the American economy, and fears of similar conflicts to follow could deter foreigners from holding dollar-denominated securities. With less demand for the securities, there would be less need for dollars.

"Perceptions are very important," said Kermit Schoenholtz, chief economist of Salomon Smith Barney. "If people believe that the events we've seen in Iraq are not one-off events, it will affect their investments."

The falling dollar has helped some U.S. companies to increase their exports, but not enough to counteract the effects of a middling global economy. "It's only offset part of it," said Frank Mendizabal, a spokesman for Weyerhaeuser, the paper and building materials maker in Federal Way, Washington. The company exported 18 percent of its sales last year, and the weaker dollar helped it to compete with producers in Latin America and Asia. But factors like a stagnant housing market in Japan still restrained demand, Mendizabal said.

Several forces may be combining to dull the effect of the exchange rate on exports. Schoenholtz said weakness of incomes and demand abroad was "a very significant portion of the reason" that the deficit in international transactions had not narrowed more.

Heightened world competition is also adding to the difficulty of American exporters' task. "I can't think of an exchange rate at which U.S. exports might be competitive with those from a very low-cost country like China," said John Lonski, chief economist at Moody's Investors Service Inc. In China's case, Lonski noted, the currency is tied to the dollar, which helps to prevent a narrowing of its trade imbalance with the United States.

Despite the decline in the trade-weighted value of the dollar, from October (when the dollar reached a peak) to January (the last month for which the Commerce Department has data), exports barely changed and imports increased by 5 percent, seasonally adjusted. At least in the short term, the dollar's movements appear to reflect foreigners' willingness or reluctance to hold American securities more than the balance of trade.

"The recent confrontation with Iraq may have convinced investors of a need to better diversify their investment portfolios away from dollar-denominated assets," Lonski said. Though he did not forecast any large-scale dumping of American securities, Lonski said that "in view of the U.S.'s record-breaking current account deficit, it seems like some decline in the dollar appears to be overdue."

Last month, according to a report by Morgan Stanley, foreign investors' demand for Treasury securities suddenly slackened. And well before the possibility of a war in Iraq began to concern investors, corporate scandals pushed foreigners to shift their portfolios away from American securities, said a senior executive of a major European bank.

"It was more that than anything else initially, and now it has to do with them feeling uncomfortable about the war," said the executive, who spoke on the condition of anonymity.

In addition to the changes in portfolios, the pace of foreigners' direct investment in the United States has slowed. The euro zone has outpaced the United States as a target for foreign direct investment for six consecutive quarters, according to figures compiled by Morgan Stanley.

All American companies, exporters and not, could suffer if foreign capital being pulled out of U.S. investments is not replaced by domestic savings. Though household savings rose to about $330 billion last year from $200 billion in 2001, the budget deficit of $158 billion cut the nation's total savings in half. This year, the overall deficit will probably be $250 billion to $300 billion, according to the latest estimates from the Congressional Budget Office.

With national savings near zero, almost all new investment by American businesses would essentially be financed with foreign money. "The only way we can grow is to get capital from abroad," said Stephen Roach, chief economist of Morgan Stanley.

The Treasury also needs foreigners to stay interested in dollar-denominated securities. According to estimates by the Bond Market Association, a trade group, foreigners hold about 35 percent of the nation's outstanding debt. The Treasury's borrowing requirements seem likely to balloon as a result of the Iraq war, the sluggish economy and President George W. Bush's tax cuts. If demand for that debt falls at the same time, interest rates could rise.

"We're asking the world to give us too much of their surplus savings," Roach said. "That's just not a sustainable way to run the economy, period."

Schoenholtz, the Salomon Smith Barney economist, thinks that the United States could regain its attractiveness to foreign investors. "If concerns about the war fade and oil prices recede sharply," he said, "then you'll be back in a position where you could argue that the chance of an economic pickup would be greater for the U.S. than in Europe or Japan."

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