The Dollar's Precarious Position
By Christopher Farrell
The state of the economy is tepid. President Bush gave a perfunctory push to his $674 billion tax cut during his State of the Union address, but the plan isn't generating much enthusiasm. Democrats have devised a number of counterproposals for stimulating the economy, all with little effect. Substantial fiscal stimulus has already been applied over the past year, but it'll take months before Washington can legislate another fiscal package to further support the economy.
However, a government policy of benign neglect in regard to the dollar is bringing much needed support to the economy -- at least in the short term. The greenback is down by more than 15% on a trade-weighted basis since last March, and the decline has accelerated over the past three months. This benefits the U.S. economy because it boosts the international competitiveness of America's manufacturing, mining, and similar industries, which sure could use some relief.
A weaker dollar, though, has several downsides. Overseas investors seem convinced that the U.S. is no longer the place to look for lush asset returns. Little wonder, considering the U.S. stock market just finished its third consecutive year of negative returns, with the prospect of another one looming. Investors are getting out of dollars and snapping up euros, partly because European interest rates are higher and partly because the Continent is perceived as a haven while the U.S. prepares for military action against Iraq.
Most worrisome is that war could turn the dollar decline into a rout, sending interest rates skyrocketing and equity prices plunging. Indeed, the day after Bush's State of the Union speech, the dollar recorded its 11th drop in 12 days. The economy is extremely vulnerable to a dollar decline, since America has never been so dependent on foreign capital. The U.S. current-account deficit, the broadest measure of trade including investment flows, is the biggest in 200 years, according to economists at UBS Warburg. The risk that war may spark a run on the dollar is the largest macroeconomic threat to the economy.
For the record, Washington has favored a strong-dollar policy for years, especially under Treasury Secretary Robert Rubin during the Clinton Administration. A strong dollar brought about a lot of economic benefits in the '90s. For instance, a stable currency and healthy economy lured slews of foreign money into the U.S. The pricey buck made imports cheaper, a critical aid in the Federal Reserve's fight against inflation. John Snow, the Bush Administration's Treasury Secretary nominee, came out strongly in favor of a robust dollar in recent testimony before the Senate Finance Committee. "A strong dollar is in the national interest," he said.
That continues to be the official, traditional Treasury line. But no one in Washington seems too worked up about the dollar's rather rapid depreciation this year. And besides the boost to manufacturing competitiveness, the greenback's decline has nudged other nations to ease monetary policies to keep their currencies from appreciating too quickly against the dollar.
Britain's experience during the Suez Crisis of 1956 is instructive. Despite a current-account surplus, the value of Britain's currency was under speculative pressure. Traders were betting that Britain would abandon sterling parity with the dollar, which had been set at $2.80 in 1949. Egypt then nationalized the Suez Canal in July, seizing control from an international consortium.
Britain, together with France and Israel, intervened militarily to take back the canal. But the U.S. government didn't back the action. Neither did the U.N. Britain found itself in a full-fledged currency crisis. It quickly agreed to pull out of Suez to get needed financial support from the International Monetary Fund.
Like all historical examples, the parallels are limited. Still, "the 'takeaway' from the Suez crisis is that unilateral political/military action can sometimes be compromised by global capital flows," says David Bowers, chief global investment strategist at Merrill Lynch. "It is one thing to attract capital to fund a private-sector, tech-inspired, capital-expenditure boom. It is quite another to fund increased military spending."
The White House would be well served to take note that the mood in the financial markets is dark. And nowhere is the tension greater than in the world's currency markets.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Beth Belton
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