The Decline of the Dollar

Speech given before the World Economic Forum
Davos, Switzerland

January 29, 1999

C. Fred Bergsten was also Chairman of the Competitiveness Policy Council (1991-97) and the APEC Eminent Persons Group (1993-95) throughout their existence. He was Assistant Secretary of the Treasury for International Affairs (1977-81) and Assistant for International Economic Affairs to the National Security Council (1969-71). He has authored or edited 27 books on a wide range of international economic topics including Global Economic Leadership and the Group of Seven (1996).


One of the major global economic events of 1999 is likely to be a sharp decline in the exchange rate of the dollar. There are at least four reasons for this prospect.

First, America's current account deficit will rise to about $300 billion (and the merchandise trade deficit will approximate $350 billion). This equates to about 3½ percent of the country's GDP, roughly the same level reached at the previous peak in the middle 1980s-after which the dollar fell by over 50 percent against both the DM and yen. The deficits are already at record levels in dollar terms. The net foreign debt of the United States will rise to almost $2 trillion.

The flipside of America's debt and deficits is of course the large creditor positions and surpluses of Japan and Europe. Japan's surplus is headed toward a record $150 billion in 1999 and the yen has already risen sharply against the dollar (and everyone else). Euroland's surplus is a bit smaller but, as the European Commission pointed out in its convergence report in March 1998, is "unusually high" and larger than at any time since the middle 1980s when it reflected the largest dollar overvaluation in history. Exchange rates always respond eventually to these external fundamentals and 1999 is likely to be the year of reckoning for the dollar for the other three reasons.

Second, the rise in the American deficit will intensify a wide range of protectionist trade pressures in the United States. The steel industry is already seeking comprehensive relief. Machine tools, semiconductors, shipbuilding, textiles and several agricultural sectors may not be far behind. If American economic growth slows enough to push unemployment up by even a modest amount, as seems likely, the trade deficit will be blamed for "exporting jobs" and the pressure on trade policy will become intense. The likelihood of a sympathetic reaction by the Administration is highlighted by its acknowledged debt to organized labor, for delivering the money and votes that propelled the Democrats to their surprise "victory" in November's midterm elections, and by the early phases of the Presidential campaign for 2000.

These protectionist pressures will focus media and public attention on the trade deficit, as will the Administration's effort to win Congressional approval for new "fast track" trade negotiating authority. Particular concern will be expressed about Japan and China, with which America's bilateral imbalances are soaring to record levels. Market attention to the external deficit will escalate sharply as a result. Previous US efforts to reduce its deficits via dollar depreciation will be recalled. This series of events will add to the prospect of a sizable dollar fall.

Third, the creation of the euro could be the proximate trigger for the next phase of the dollar decline. It is now widely agreed that the euro will become a major global currency, perhaps eventually challenging the dollar for global financial supremacy. That historic development will entail a large portfolio diversification from dollars to euro, perhaps reaching $500 billion to $1 trillion over the next few years.

The international ascent of the euro will produce a sharp initial rise in its exchange rate. Euroland will export considerable quantities of capital, increasing global supply of the new currency along with demand for it. But the stock adjustment, mainly out of dollars, will occur much more quickly than this flow effect. A euro appreciation of about 10 percent is called for to restore sustainable current account positions but overshooting is quite possible and some European economists anticipate appreciation of as much as 25-40 percent.

Fourth, the US economy is likely to slow sharply in 1999. American interest rates are still quite high in real terms by historical standards. Its short-term rates are a good deal higher than Europe's and they will probably fall considerably farther. European interest rates may drop too but the differential in favor of the dollar is likely to decline. Any recovery in Japan would probably produce higher rates there and add to the reduction in transPacific yield differentials as well.

Structural, systemic and cyclical considerations therefore all point to a dollar downturn over the coming year. Our latest calculation of fundamental equilibrium exchange rates at the Institute for International Economics suggests equilibrium rates of about 1 euro = $1.25-1.30 and $1 = 100 yen. This implies that the required dollar decline will average around 10-15 percent, about as much as in 1971-73 (though much less than in 1985-87).

Market rates typically overshoot, however, so the dollar could depreciate well beyond these levels in its initial fall. Such an overshoot could be quite uncomfortable for all countries involved. An excessive appreciation of the yen, like its rise to 80 to the dollar in early 1995, could severely retard Japanese recovery. A sharp rise in the euro, while helping to establish the new currency's market appeal, could increase unemployment across Europe. The situation in the United States is complex: substantial dollar depreciation would help correct the trade deficit and check protectionism over the next couple of years but, with the economy still near full employment, might also trigger inflationary pressures and push interest rates back up just when the economy was slowing down.

There will thus be a need for the G-3 (Euroland, Japan, United States) to manage their exchange rates much more actively in the upcoming period . The best approach, as proposed by the new German government and supported by Japan and the other continental European members of the G-7, would be installation of a regime of "controlled flexibility." The G-3 could seek agreement on wide (20-30 percent) equilibrium ranges, both in the transition period to the euro and subsequently for the longer run, and try to avoid severe dollar overshooting on the downside. They could deploy joint intervention, additional interest rate cuts in Euroland and Japan, and perhaps fiscal expansion in the United States to defend the announced ranges against excessive dollar weakness. Europe will also need to adopt serious supply-side measures to reduce unemployment by increasing the flexibility of its labor and capital markets; the alternative of substantial fiscal expansion, in addition to violating the Stability Pact, would produce a Reagan-Volcker policy mix (instead of the much more desirable Clinton-Greenspan mix) that includes much higher interest rates and much greater euro appreciation.

The lesson for the longer run is that floating exchange rates, like "fixed" rates before them, frequently degenerate into prolonged misalignments that generate substantial economic dislocations, set the stage for new bouts of financial instability, and threaten the global trading system with major outbreaks of protectionism. If left unattended, global instability is likely to worsen in the future with the advent of the euro because then the world's two leading economies, both continental in scope with relatively little reliance on international transactions, could be frequently tempted to practice "benign neglect." Both short-run market prospects and long-term systemic considerations thus point to the urgent need for adoption of more stable currency arrangements among the world's largest economic powers.