Commentary: How to Avoid a Free-Falling Dollar

By Rich Miller and David Fairlamb

President Bush was getting ready to head off to his first economic summit with the Group of Eight in Genoa when he accidentally triggered a tempest in the currency market. In an interview with foreign reporters on July 18, Bush said the strong dollar has "pluses and minuses" for the U.S. and that it was up to the markets to decide its fate. Whoops. That less-than-ringing endorsement helped trigger a sharp 3% slide against the euro, as speculators bet that the Administration was shifting gears and wanted the dollar to fall. Treasury Secretary Paul H. O'Neill, who made a similar gaffe earlier in the year, scrambled to the rescue, spending the next week talking up the dollar. Make no mistake, he asserted: The Administration still believes in a strong dollar. By July 25, the greenback had recouped much of its losses.

Bush's loose lips could have turned into something far worse than your run-of-the-mill Presidential faux pas. True, there may very well be some good political and economic reasons for the Administration to want a moderately weaker dollar. But it can't afford to say so outright, for fear of disrupting the market and triggering a dollar free fall. The very fact that the dollar has reached such stratospheric levels puts it in a particularly vulnerable point. The reason: With a shaky stock market, a stagnant economy, and a bulging trade deficit, the slightest sign of a downturn in the dollar could send currency investors and speculators stampeding for the exits.

EUROPEAN PRESSURE. At the same time, pressure for a policy change is mounting. Such companies as H.J. Heinz (HNZ ), Sherwin-Williams (SHW ), software security maker Symantec (SYMC ), Kimberly-Clark (KMB ), Pfizer, and International Paper (IP ) have complained that the strong dollar has hurt their profits. A weaker dollar would boost their exports and spur the sluggish economy. Farmers and labor unions are unhappy, too. Not surprisingly, Congress is responding. At a hearing on July 25, lawmakers asked former Treasury Secretary Robert E. Rubin if the time is right to talk down the dollar. Rubin, now co-chairman at Citigroup Inc. said, no way.

Europe is also angling for a shift in the U.S. stance. The leaders of Germany, France, and Italy pressed Bush to join them in calling for a lower dollar. They argued that the strong greenback pushes up inflation in Europe by driving up the cost of imported commodities, energy, and other products priced in dollars. That's preventing the European Central Bank from cutting rates. "The dollar's strength is having a negative impact on the global economy," one Italian government official said.

But the Administration dare not accede to demands for a weaker dollar because that would risk sparking the very crash it seeks to avoid. A collapse would send shock waves through the U.S. economy, pushing rates higher and the stock market lower as foreign investors yanked money out of the U.S. en masse.

The chance of a crash might seem remote, given that the greenback's rise has been fueled by the belief that the U.S. economy remains a better bet than Europe's or Japan's. But policymakers can't afford to ignore the risk. While O'Neill has publicly played down the possibility, privately some Administration officials are worried. So, too, are their European counterparts. A whiff of what could happen came when the dollar tanked before the summit, in part due to the mix-up over Bush's remarks. It shed that 3% in just a day.

Adding to the currency's vulnerability: In recent months, foreign-capital inflows have shifted away from direct investment in plant and equipment to more mercurial investments in stocks and bonds. They can be yanked out at a moment's notice. With the U.S. needing $30 billion a month in foreign capital to finance its current-account deficit, even a modest change in investor sentiment could have devastating effects. If the U.S. economy fails to pick up later this year as investors expect, the dollar could be in for a tough time, some analysts say.

So the Administration is left with vehemently denying any suggestion that it's gone soft on the greenback or is abandoning the strong dollar policy of its predecessor. The trouble, though, is the more the Administration pounds its chest about its allegiance to the strong dollar, the higher it encourages the currency to go. And the bigger its dilemma gets.

Miller covers economic policy from Washington. Frankfurt-based correspondent Fairlamb contributed from Genoa.

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