Let the Dollar Fall

Op-ed published in the Financial Times

July 17, 2002

The exchange rate of the dollar has declined steadily and gradually for the past six months. It has fallen by a trade-weighted average of about 10 per cent and by about 20 per cent against the euro. This represents a reversal of about a quarter of the dollar's rise from 1995 to the beginning of this year.

A substantial correction of the overvalued dollar was as inevitable as a substantial correction of the overvalued US stock market. America's current account deficit is approaching $500bn, or 5 per cent of gross domestic product, far higher than before the sharp dollar falls of the early 1970s, late 1970s, mid-1980s and mid-1990s.

The only issues were by how much and when the dollar would correct. The US can probably sustain current account deficits of 2 to 2.5 per cent of GDP, about half their present magnitude. Since every 1 per cent fall in the dollar produces an improvement of about $10bn in the current account, with a lag of about two years, an ultimate depreciation of perhaps 25 per cent was to be expected. The decline to date has achieved about a third of this.

The timing of the adjustment has been ideal. The dollar's fall has been so gradual and so smooth that there has been no noticeable impact either on prices or on interest rates. Moreover, the US economy is in the early stages of recovery and is thus operating with considerable unused plant capacity and unemployed labour. Inflationary pressures are virtually absent and interest rates are at their lowest levels in 40 years. Any pressures that a falling dollar might place on prices or on money markets would thus be relatively easy to absorb.

In addition, the US economy still looks much stronger than Europe's or, especially, Japan's. The continued surge of US productivity growth, which continued remarkably throughout the recession, virtually assures medium-term growth of at least 3 per cent and probably a good bit more. In spite of the corporate scandals, there is little risk of capital flight and a free fall of the dollar that could convert orderly adjustment into a disruptive destabilisation.

Some observers worry that a continued dollar decline would further weaken the US stock market and thus jeopardise recovery. Herd mentality is always possible but a weaker dollar should, on the contrary, strengthen the outlook for equity markets in at least three ways. It improves the profits of American multinational companies by translating their foreign earnings into more dollars. It bolsters the price competitiveness of the US economy as a whole. It of course enables foreign investors to obtain more cheaply the currency with which to buy dollar equities (and other assets). Hence the dollar's slide should help halt, rather than accelerate, the drop in stock prices.

US policy has supported an orderly realignment. The Bush administration quietly dropped the strong dollar rhetoric of its predecessors about a year ago (although the dollar remains quite strong, against any reasonable historical benchmarks, as noted above). It has clearly signalled that it would not intervene to impede the correction. A change in this stance is virtually unimaginable.

The only problem so far has been the reaction of a few other countries. Japan has intervened heavily in an effort to resist the dollar's adjustment against the yen even as its trade surpluses are again soaring. Taiwan has done so to a lesser extent. China, South Korea and a few other countries continue to pile up dollar reserves rather than let their currencies fully reflect their economic fundamentals. Some Europeans have begun to complain and that clamour will undoubtedly grow as the euro climbs back towards its starting-point of early 1999.

To be sure, all non-dollar countries will experience some erosion of their price competitiveness as the dollar falls. This is the inevitable flip side of the reduction in America's unsustainable trade deficit. But all main currencies are rising together against the dollar so none of their trade-weighted averages is appreciating very much. In any event, exports to the US account for less than 3 per cent of the eurozone and Japanese economies, so even large changes in those sales will have minimal impact on them. Moreover, the anti- inflationary impulse from their currencies' appreciation will permit all these trading partners, especially the eurozone, to ease monetary policies, neutralising any adverse effects.
Hence, the dollar should be permitted to complete its necessary correction over the next year or so, with, one hopes, a trajectory as orderly as that of the past six months. The US should maintain its policy of non- intervention. The US and the Group of Seven industrial nations should insist that other countries refrain from taking any measures that would impede the adjustment. The result will be both a stronger world economy and removal of one of the main threats to its sustainable growth in the future.