Why the Dollar Isn't About to Fall
By David Fairlamb
The strength of the dollar didn't feature on the official agenda of the G8 summit in Genoa. But it quickly surfaced when the leaders of the world's seven richest countries and Russia discussed the state of the global economy on the meeting's second day. The heads of government from the three eurozone nations represented at the summit -- France, Germany, and Italy -- told U.S. President George W. Bush that the strong dollar is fueling inflation in Europe by driving up the cost of imported commodities, energy, and other products that are priced in dollars. That, in turn, makes it more difficult for the European Central Bank to cut interest rates to stimulate the slowing European economy.
The dollar has appreciated almost 30% against the euro since Jan. 1, 1999. That has helped European exporters. But increased sales abroad have not been enough to offset the greater cost of imports. "The dollar's strength is having a negative impact on world trade and the global economy," said one Italian government official after the close of the meeting. "You just have to look at the price of energy to see the problems it's causing countries who have to import fuel."
The Europeans also argue that the strong dollar is harming world trade by making dollar-denominated exports from many developing nations more expensive. That in turn means poorer countries sell less and therefore have less money for imports and investment. The strong dollar's critics add that they're worried about possible currency-market turbulence when the greenback does eventually start losing ground. The general assumption among European economists is that the U.S. currency is as much as 20% overvalued and that it could fall in a sudden and volatile way when the markets move to correct the price. The turmoil would cause uncertainty, further hurting exports and growth.
Despite the warnings, Bush made it clear that the U.S. Administration opposes intervention and favors a strong-dollar policy. "There are some who want us to artificially weaken the dollar," he said. "But that's not the role, in my judgment, of the country. The market ought to do that, not the nation." He's right, and the sooner European leaders realize that, the better. They need to make structural reforms to strengthen the euro, not expect the U.S. to come to their rescue.
Of course, even if the U.S. wanted to weaken the dollar, it wouldn't be easy. True, on July 19, Bush observed that the strong dollar does hurt U.S. exporters. That comment was made after a number of powerful U.S. interest groups -- including the National Association of Manufacturers, the AFL-CIO, and the U.S. Farm Bureau -- demanded that the President move away from the strong-dollar policy to give exports and the economy a boost. It was immediately -- and wrongly -- interpreted by the markets as signaling a more flexible approach to the currency, which lost two cents against the euro to close the week of July 13 at 1.146 euro.
The White House and Treasury were horrified and quickly insisted that there had been no shift of policy. "I am not in Yankee Stadium yet," says Treasury Secretary O'Neill. Back in February, O'Neill had said he would rent Yankee Stadium and hire a brass band if the Administration's attitude toward the dollar changes.
VITAL FOREIGN INFLOWS.
It's clear after Genoa that Bush may hear U.S. companies complain about what the strong dollar is doing to U.S. manufacturing and corporate balance sheets. He also hears what the Europeans say. "But he's not listening," insists David Gilmore, an analyst at FX Analytics, the foreign exchange research house. "With growth slowing in Europe and already weak in Japan, the Administration rightly questions what good -- if any -- a falling dollar would do for U.S. growth." Bush's advisers argue that it's the relative rates of growth that determine how much the U.S. can export abroad, not the value of the currency. "The far more reasonable, though rarely mentioned, concern -- as it's anti-consumer -- is how U.S. firms lose market share due to cheaper imports," says Gilmore.
The reason Bush needs a strong dollar, of course, is that he wants to continue funding the huge U.S. balance of payments deficit, currently running at around $30 billion a month. A top Bush aide recently said foreign savings "are the oxygen keeping the U.S. economy alive." If the dollar falls or the Administration gives the perception that it favors a weaker dollar, that oxygen could suddenly run short.
A slowdown of inflows to the U.S. could deprive the economy of the cost of capital needed to fund consumption and investment. And it would wreck havoc on U.S. asset prices. Foreigners are currently pouring up to $25 billion a month into U.S. stocks and bonds. If attitudes toward the dollar change, that capital flow could quickly reverse, forcing the Federal Reserve to raise interest rates in order to attract inflows to the U.S. Higher rates would most likely nip a nascent U.S. recovery in the bud. "The deep-seated fear is that the dollar could go into a free fall, driving U.S. interest rates up and asset prices down," says Gilmore. "Fine if the economy was growing at 4% to 6%, but not when it's hovering around zero."
LISTEN UP, EUROPE.
Hence, the U.S. is unlikely to change course soon. And the sooner the Europeans realize that, the better. Bush is right when he says the dollar's value should be left for the markets to decide. Ultimately, the dollar's strength reflects the greater flexibility and creativity of the U.S. economy.
The best way to drive its value down is for the European governments to make the structural reforms that would make the eurozone economy more flexible and competitive. Until that happens, the dollar is likely to remain strong -- whatever the Europeans may want or Bush may say.
Fairlamb covers business and economics for BusinessWeek in Frankfurt
Edited by Beth Belton