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A Weak Dollar Hurts Globally

The September 11 attacks and the looming recession in the U.S. have spurred fears that foreign investors may start pulling money out of the country. That could drive the dollar down, impairing a U.S. recovery, as companies find it harder to raise capital overseas.

But the dollar's central role in the world financial system means that a plunge could make life much worse for other nations, notes David A. Levy, vice-chairman of the Jerome Levy Economics Institute at Bard College. One reason, of course, is that big exporters such as Japan and Germany would find it harder to sell to American consumers and businesses, since a falling dollar means higher prices for imports.

Beyond that, foreign investors would be hit by a reverse "wealth effect" if the dollar declined. In the second half of the 1990s, such investors, lured by America's rapid growth and high equity returns, gobbled up trillions in dollar-denominated debt and equity. From yearend 1995 to June, 2001, the value of foreign-held assets in the U.S. rose from $3.5 trillion to $7.8 trillion. Foreign direct investment in U.S. companies more than doubled, to nearly $1.5 trillion.

A sharp plunge in the dollar would dramatically reduce the value of these assets, reducing the wealth of foreign investors. That could drag down consumption and investment overseas, and damage financial systems in countries that had grown accustomed to using the dollar as a safe currency. A falling dollar would be a major deflationary influence on the world economy, notes Levy. "The weaker the dollar, the more damage it does to the global economy."

It's not just holdings of U.S. assets that are at risk. Because of the strength of the dollar and of the U.S. economy in the 1990s, it became commonplace for even foreign companies to issue debt denominated in dollars. Dollar-denominated bonds now account for 51% of all international bonds outstanding--that is, bonds issued outside the home country or home currency of the borrower. That's up from 34% in 1995. If the dollar falls, those bonds would all become much less valuable to the investors holding them--and much more of a problem for the global financial system. Few would disagree that the U.S. needs to reduce its reliance on overseas supplies of energy. The question is how. Now, a new study from the Energy Dept.'s Energy Information Administration offers evidence suggesting that tax incentives can help boost domestic production of energy.

The report, released on Sept. 27, analyzed the long-term impact of tax credits enacted in 1980 for "nonconventional" fuel production, which includes extracting oil from shale and natural gas from coal seams. The net impact of the credit is to significantly boost the effective price that companies receive for their production.

Surprisingly, the report finds that such tax credits were a key factor in a jump in domestic natural-gas production in the 1990s. From 1990 to 1999, the increase in natural gas produced from coal seams--a technique covered by the credit--equaled 57% of the total growth in U.S. natural-gas production. Moreover, major energy companies that took advantage of tax credits increased natural-gas output by 26% from 1990 to 1999. Companies that didn't get tax credits saw natural-gas output fall 14%.

Obviously, other factors besides tax credits helped push up natural-gas production in the 1990s, including rising natural gas prices. Nevertheless, with the Senate slated to take up energy legislation by the end of 2001 and the tax breaks due to expire a year later, the report gives ammunition to those who support the use of tax incentives to boost domestic energy production. Bad news for European policymakers: Joblessness in the 12-nation euro zone has started climbing. After falling to 8.3% in June, July, and August--its lowest level in two decades--economists now expect the unemployment rate to rise for at least the next year. Sharda Dean, euro zone economist at Merrill Lynch & Co. in London, predicts the figure will reach 8.9% by the third quarter of 2002.

That's a smaller jump in joblessness than is expected in the U.S., where even the most optimistic forecasters predict the unemployment rate will jump a percentage point or more in the next year. Part of the difference is that the slowdown is expected to be less severe in Europe.

Equally important, unemployment is expected to rise more slowly in Europe because tight regulations make the labor market more rigid. France, Europe's second-biggest economy, created jobs at a brisk pace in the first half largely because the introduction of the 35-hour workweek forced even reluctant companies to hire more workers. Meanwhile, laying off unwanted staff is difficult because employers have to justify their cuts and offer generous severance.

Still, unemployment, already high by U.S. standards, is rising even in countries with regulated labor markets. French joblessness ticked up in August for the third straight month, after hitting an 18-year low in May. And unemployment is up in Germany since first quarter 2001 and now stands at 9.3%.

With elections due in France and Germany next year, pressure is mounting on policymakers to reverse the jobless tide. Business leaders such as Rolf Breuer, the head of Germany's Deutsche Bank, say the long-term solution to Europe's high unemployment rate is to loosen regulations. But with politicians worrying that liberalization would add to unemployment, little action seems likely anytime soon.

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