The Drag On The Dollar Is Made In Japan

It should be the best of times. Inflation is quiescent, employment is rising, and the U.S. economy is chugging smartly along. Yet the currency markets have the jitters: Since the beginning of the year, the dollar has fallen by some 12% against the yen. Could it be the embarrassing Whitewater hearings? The latest failure of trade talks with Japan? Or the rising odds of an invasion of Haiti?

On a day-to-day basis, any of these could push the dollar up or down, making the short-run fluctuations of the currency markets hard to predict or understand. "There is a temptation to attribute dollar swings to whatever is going on that week," says Maurice Obstfeld, an economist at the University of California at Berkeley, "but when the dollar suddenly recovers, what can we make of that? Whitewater and Haiti didn't just go away overnight."

But the long-run decline of the dollar against the yen--35% over the past four years--does have a clear-cut explanation. The key is the massive and persistent U.S. trade deficit with Japan, which has pushed the dollar down relentlessly against the yen. Meanwhile, with the U.S. running trade surpluses with Europe and Latin America, the dollar has risen against an average of the currencies of its trading partners (chart).

BEST STRATEGY. Because the value of the dollar against the yen is so closely tied to the $60 billion U.S.-Japan trade gap, there's little the Federal Reserve can do to prop it up. Without major changes in the trade relationship between the two countries, currency interventions or even interest-rate hikes, measures that Fed Chairman Alan Greenspan has alluded to in his recent testimony before Congress, are doomed to fail.

To keep the dollar from falling further against the yen, Washington's best strategy is to attack the fundamental causes behind Japan's staggering trade surpluses: tax and regulatory policies in that country that encourage abnormally high savings rates, tolerance of private-sector collusion to exclude foreigners, ridiculously high hurdles for foreign investors, and a trade policy that favors producers over consumers.

Meanwhile, the drag on the dollar is increasing. America's sustained current-account deficits helped drive it to world-class debtor status and transferred more than $600 billion abroad in the 1980s, much of it to Tokyo. So long as the Japanese were recycling their dollars into U.S. office buildings, golf courses, and cattle ranches, that wasn't much of a problem. But Japan's recession and the collapse of real estate worldwide forced Japanese investors to sell U.S. assets to improve their balance sheets. And an estimated $300 billion loss for Japanese investors and central bankers in U.S. currency and assets has soured them on further purchases. Now, the dollars that Japanese exporters earn are being tossed into the currency markets rather than reinvested in U.S. assets, further depressing the dollar. "That's why the only solution [for a weakening dollar] is to bring down the U.S. trade imbalance," says Lawrence Chimerine, an economist at the Washington-based Economic Strategy Institute.

MAGNIFIED EFFECT. To be sure, trade is not the only force driving currency values. Only about a quarter of the more than $1 trillion in daily currency trades can be attributed directly and indirectly to trade in goods and services. Speculation, hedging, and investment account for the rest, which explains why the dollar can gyrate so wildly in the short run.

Moreover, with corporations and countries around the world using the dollar as their main trading currency, any downward pressure on the dollar is magnified. "Everyone is worried about the dollar's value because they are using dollars for invoicing and for reserves, and that just makes it more sensitive and volatile," says Michael B. Bordo, an economist at the International Monetary Fund.

The dollar has also been weakened by the behavior of U.S. mutual funds, which are going global in a big way. Spurred by the lure of foreign investment opportunities, capital is flowing out of the country at an estimated $10 billion to $12 billion a month, making the U.S. the world's biggest capital exporter--a surprise for a country that has not been able to increase its savings rate. This requires that mountains of dollars be swapped for European and Asian currencies, putting even more downward pressure on the dollar, says Kemper Financial Services Chief Economist David Hale.

If the yawning trade gap with Japan clearly explains the dollar's decline against the yen, what about the dollar's 10% drop vs. the German mark since January or its 8% gain against the Mexican peso? Beyond the impact of trade imbalances, economists also point to relative inflation rates, money growth, and interest-rate differentials. For example, the strength of the German mark comes from a stronger-than-expected economic recovery as well as the markets' belief that the Bundesbank will do whatever is necessary to keep inflation in check.

Moreover, in the short run, currency traders often respond to expectations about future economic trends rather than present conditions. Along with the Federal Reserve, currency traders are searching the horizon for any signs of impending U.S. inflation, even with month after month of relative price stability.

OUT OF STEP. The Federal Reserve and other central banks believe that they can influence exchange rates even though the size of their currency intervention is minuscule relative to the market. "The foreign exchange market is a herd of steers, and central banks are herd dogs. They bark and nip at the heels of the steers, with the aim of moving the herd in the desired direction," explains Harvard University economist Kathryn M. Dominguez. It seldom has the desired effect over time, however. After all, a U.S.-led $3 billion greenback purchase by 17 central banks on June 24 did fothing to halt the dollar's slow surrender to the yen.

When an exchange rate is not being moved by an overwhelming trade gap, central banks can indeed affect values--but only by backing up currency intervention with substantial economic-policy moves, such as interest-rate hikes. In 1992, for example, European governments weren't willing to make the economic-policy changes necessary to hold the European system of managed exchange rates together. Central bankers in Britain, France, and Italy stoutly defended their currencies with forceful interventions, but the currencies plummeted nevertheless since the countries' economic policies were out of sync.

So far, Washington has avoided tackling the basic economic forces driving up the trade imbalance with Japan. True, holding trade talks may gain some marginal concessions that help specific industries. But the Clinton Administration can't let Japan off the hook for the broader economic reforms needed to close the trade gap.

Commentary/by Paul Magnusson

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