AmerCon : Econ : Currency Markets

New Democrats Online
2004.12.16
Commentary and Analysis

The Shrinking Dollar

Any American planning overseas travel knows the value of the dollar has plunged in recent
months. But aside from suddenly pricing that long-planned European vacation out of sight,
this development has rattled world currency markets and unsettled the foreign owners of
much of our national debt.

At his "economic summit" yesterday, President Bush tried to address these jitters by
promising to "work on" his administration's budget deficits in the next Congress. It's about
time he paid attention to the issue, at least rhetorically. Since early November, the dollar
has hit new record lows against the euro almost every week. It is at 10-year lows not only
against almost all other major traded currencies -- the British pound, Swiss franc,
Japanese yen, Swedish kroner, Danish krona, Australian dollar, and Canadian "loonie" --
but also against the Turkish lirasi, Mexican peso, and Bulgarian lev.

Is it time to panic? No. There are good things about the decline of the dollar. But insofar as
it reflects a negative international judgment on the debt-ridden fiscal policies of the Bush
administration, it's a sign that we need more than empty rhetoric about changing those
policies in Washington. This is especially true at a time when that rhetoric is sharply at
odds with the administration's apparent determination to make the situation worse with
more tax cuts, more unfunded defense spending, and more indifference to the
big-spending ways of the GOP-controlled Congress.

To state the positive first: There are some good reasons for the dollar to fall. To date, the
decline has simply brought it back to levels prevalent before the Asian financial crisis in
1997. A relatively strong dollar in the following years was important for global stability, but
also exacerbated America's global trade and current account imbalances. These are now
above 5 percent of U.S. GDP -- levels unprecedented in the modern era, and levels which
are generally thought to precede a period of extreme financial stress. .

In these circumstances, a decline is part of a natural market response and can help
rebalance the accounts. By making American exports less expensive abroad, it can help us
sell our goods more easily, provide some support to manufacturers, and help bring the
deficits back to sustainable levels. An essential and still missing element, however, is an
upward revaluation of China's yuan -- the only major international currency not to rise at all
against the dollar in the past two years -- and similar decisions by some other Asian trade
partners.

So a lower dollar can have some good consequences. But it is only a partial solution to
global trade imbalances. In fact, the dollar has been declining, though unevenly in different
parts of the world, since early 2002. By September it had already dropped nearly 50
percent against the euro and pound, and 20 percent against the Japanese yen. (A euro
cost 84 cents in June of 2002, and $1.21 in September. It now requires about $1.33.) But
the trade imbalances have grown anyway -- the imbalance with the 12 euro
countries, for example, has risen from $73 billion in 2002 to a likely $95 billion this
year.

While exports have grown, probably helped by the dollar decline, imports have grown even
faster. Low interest rates, currency hedging by European businesses, and high U.S.
demand have kept American consumers buying imported goods despite currency
depreciation. Thus Americans bought 665,000 European cars for $17 billion in the first
three quarters of 2002, for example -- and despite higher euro rates, bought 746,000 cars
for $22 billion in the first three quarters of 2004.

The imbalances, therefore, arise from causes beyond earlier high dollar rates -- and this
brings us to the less welcome implications of dollar decline.

The other factor in the growth of current account imbalances is a sharp decline in
America's savings rate since the year 2000, driven by a nearly $700-billion
reversal of government finances in five years -- from a $240 billion surplus in
2000 to a $420 billion deficit in 2004 -- as well as falling personal savings. The net
national savings rate, as of last year, had dropped to 1.2 percent of GDP. This is a
level last touched in 1934. A falling dollar will not compensate for this shift in
fundamentals.

And of course a falling dollar can have consequences well beyond trade. Rapid and
unmanageable drops can cause financial panic and recession. Over longer terms, a
weaker dollar can be inflationary and force interest rates up. As last week's Economist
magazine points out, with its striking cover of a white caterpillar nibbling holes in a dollar
bill, it can have the extremely unwelcome consequence of eroding the dollar's 60-year role
as the world's reserve currency. This would mean a permanently more difficult financial
environment for Americans, in particular for servicing international debts and purchasing in
global energy markets.

Altogether, the drop in the dollar is not a cause for panic. If the administration is able to
restore some fiscal credibility, and manage a more effective approach to China, the drop
can bring a healthy rebalancing of the global trade accounts, and more sustainable
growth. But if attempts to reassure the world and the markets about the budget with words
are combined with actual policies that make them bigger, U.S. credibility and market
confidence will of course continue to decline. Then the result could be crisis and financial
shock; meaning that this winter's currency headlines will be remembered not as a healthy
market adjustment, but as the first dark clouds of a nasty storm.

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