The Dollar: Don't Raise Interest Rates

Which world currency has risen, on a trade-weighted basis, more than 4% in the past year? The strong Japanese yen? The powerful German mark? Nope, it's the U.S. dollar. Surprising as it may seem, given the hysteria in the financial markets, the dollar appears to be doing rather well.

Sure, the dollar is down about 8% against the yen since a year ago, but a dollop of economic savvy will show that the real story lies in the strength of the buck vis-a-vis the rest of its trading partners. Japan absorbs only 15.6% of all U.S. foreign trade, according to the Dallas Federal Reserve. Canada takes 20% of U.S. trade, and the dollar is up 10.9% against the Canadian currency from May, 1993, to May, 1994. Europe takes 25% of America's foreign trade. Yet from May to May, the dollar is up 5% against an average of Europe's currencies. PACNIC, or the Pacific Newly Industrial Countries, absorbs 18% of U.S. trade--more than Japan. The dollar? It's up 5.5% against their currencies. The dollar is also up 1% against the Mexican peso and 8.9% against the rest of Latin America's currencies. So much for the dollar crisis.

Indeed, the current roiling in the currency markets is really a "yen crisis." Almost half of the $150 billion U.S. merchandise trade deficit is in autos and consumer electronics--much of that imported from Japan. This trade imbalance has so far proved impermeable to a currency solution. Japan's markets are simply more closed than those in the U.S. or Europe. A drop in the dollar from 280 to 100 yen over the past decade has not solved the problem.

Political instability aggravates the yen crisis. Japan has had four governments in 12 months. Leadership paralysis has blocked deregulation, a tax cut, and pump-priming, all designed to boost growth, hike imports, and ease pressure on the yen. The bizarre choice of a Socialist, Tomiichi Murayama, as new Prime Minister, can only prolong the deadlock.

What should Washington do? The big question buzzing through the Clinton Administration is whether the U.S. should act to bolster the dollar, even if it jeopardizes the country's economic recovery. The simple answer is "no." Federal Reserve Chairman Alan Greenspan should continue to pursue the domestic goals of price stability and economic growth. With auto sales already softening and the economy slowing, another big rate hike could tip the U.S. back into recession. To solve Japan's yen crisis? It makes no sense.

Like old generals looking backward, not forward, traders are oblivious to the recent changes in the U.S. economy that actually make the dollar undervalued. They are blind to the growth in productivity. They can't see the dramatically shrinking federal budget deficit, smaller as a percentage of gross domestic product than either Japan's or Germany's. They won't acknowledge that the U.S. is now the low-cost producer of most industrial goods.

The facts are that inflation remains subdued at 21/2%, higher commodity prices are not being passed on to consumers, and a lower dollar is not leading to a price surge.

This doesn't mean that the Clinton Administration brims with virtue. Talking down the dollar last year undercut confidence, and it was a mistake. But despite its foreign policy mess, the Administration has been essentially correct in its international economic policy. The White House has been focused and forceful in promoting exports and opening foreign markets. Until Tokyo takes responsibility for its gargantuan surplus, currency markets will remain in turmoil.

As for the bond and currency traders, they will eventually learn that economic fundamentals are more important than coffee beans. If the Fed focuses on these fundamentals, it can guide the U.S. and the world into years of economic growth. If it caves in to the pressure, recession is a clear and present danger.

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