Global Policy Forum

By Desmond Lachman*

American policymakers can probably do little to arrest the downward slide in the dollar. But it would seem to be a foolhardy and politically risky strategy for Treasury Secretary John Snow and the leading industrial nations to effectively endorse a policy of benign neglect on the matter, as they did last week. It would be better to let markets gradually rediscover that the emperor has no clothes rather than to have the emperor himself publicly declare his preference for strutting about in the nude.

Since its lofty peak in early 2002, the dollar has plummeted by about 25 percent against the euro. More disturbing, in the past two months the dollar's decline has gathered considerable momentum. To understand the risks of a hands-off policy, it's important to understand the basic forces underlying this collapse, and to be fully aware of the fragile global economic setting in which the dollar's decline is occurring.

Two basic reasons appear to explain the dollar's recent slide. The first is the record current account deficit of almost $500 billion that the United States is experiencing. This deficit reflects the massive imbalance between imports and exports of goods and services. Financing it requires net inflows of foreign capital to the United States on the order of $1.5 billion a day if the deficit is not to exert downward pressure on the dollar.

To be sure, throughout the second half of the 1990s, the dollar gained in strength even as the United States was experiencing historically high current account deficits. But it rose on the back of huge amounts of foreign capital being drawn to invest in a buoyant U.S. economy. After the collapse of U.S. equity markets early in 2000, this country progressively lost its allure as a magnet for investment.

A second, though lesser factor in the dollar's recent slide is an apparent change in foreign central banks' preference for the greenback. This appears to be particularly the case among Middle Eastern central banks following the war in Iraq. The importance of the attitude of foreign central banks toward the dollar is underlined by the fact that approximately 40 percent of the U.S. current account deficit is financed by official purchases of U.S. Treasury paper. This compares with only 15 percent a few years ago.

In normal times, an orderly decline in the dollar would be a welcome development. By cheapening American exports and increasing the cost of imports here, the fall of the dollar would facilitate the needed long-run adjustment in the current account deficit. Moreover, by raising import prices it would play a useful role in countering the rapid pace of disinflation that is bothering Federal Reserve Chairman Alan Greenspan.

The trouble is that we do not live in normal economic times. Both Japan and Germany, the world's second- and third-largest economies, respectively, again appear to be in recession, and both are experiencing differing degrees of deflation. An appreciation of their currencies would only add to deflationary pressures in these countries as their exporters lost competitiveness abroad and cheap dollar imports flooded their domestic markets.

For Germany in particular, a rising euro is the last thing needed, now that it has conceded the running of monetary policy to the European Central Bank. Moreover, Germany is obligated by the European Fiscal Stability Pact to tighten budget policy at precisely the time it should be spending more in a countercyclical fashion. The 15 percent increase in the euro over the past six months has had the same effect on the German economy as would a 1 percent hike in European interest rates.

Given the European Central Bank's track record of being painfully slow to reduce interest rates, and its misplaced obsession with fighting inflation, any further decline in the dollar runs the risk of throwing Germany deeper into recession. This can hardly be in the United States' long-term interest, as a weaker Germany would heighten the already tense trade relations between the United States and Europe. Moreover, a depressed Germany would provide U.S. exporters with fewer opportunities to sell their goods abroad, thereby blunting the advantages conferred on them by a weaker dollar.

Perhaps the greater risk of allowing the U.S. currency's value to be fully determined by the market is the potentially destabilizing effect a further rapid fall in the dollar could have on U.S. financial markets. A decline in the dollar has the effect of reducing the return to foreigners on their U.S. investments. For example, while the S&P 500 has increased by around 5 percent in dollar terms since the beginning of 2003, it has declined by about 10 percent in euro terms because of the dollar's depreciation against the euro. Should foreign investors become disenchanted with U.S. investments, the risk is not only that they would not put new money into the United States but also that they would begin selling their large holdings of U.S. securities. In that event, American security prices would be driven down and the depreciation of the dollar would gather momentum, which would only heighten their disenchantment with U.S. assets. This could plunge the U.S. equity and exchange markets into a downward spiral.

If experience is any guide, events in the currency markets will likely force the G-8 to change its hands-off attitude toward the dollar before the summer is over. It's to be regretted that the European Central Bank is not already cutting European interest rates aggressively to at least temper the decline of the dollar. Coordinated intervention should also be considered now, as a preemptive measure. Early action, rather than in the midst of a crisis, would be more likely to produce an orderly depreciation of the dollar, which would be in the United States' interest.

About the Author: The writer is a resident fellow at the American Enterprise Institute

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