Heading Off a Dollar Crisis

The dollar is sliding. The Federal Reserve is warning about deflation. The twin budget and current-account deficits are soaring. And the nation is hooked on a $2 billion-a-day infusion of foreign capital to keep it going. Should we be worried that a dollar crisis threatens the economy? No. And not anytime soon. But long-term, the possibility cannot be ignored.

So far, the falling dollar is a boon. It's lifting profits for corporations with operations overseas. It's boosting import prices, providing many U.S. outfits with rare pricing power. Higher earnings are putting wind into the stock and bond markets. The last time the U.S. had a sharp decline in the dollar, in 1985-86, the stock market rallied 43%.

But there's no denying that sentiment has turned against the buck. And for good reasons. U.S. interest rates are half those of Europe, and the specter of deflation means they are likely to remain low well into the future. The U.S. is now the world's biggest debtor nation, owing $3 trillion -- an amount equal to the French and German economies combined. America's current-account deficit is pushing 6% of gross domestic product, a record, and may hit 7%. For the first time, the U.S. is paying foreigners more on their investment income from holdings in America than it receives from its own assets abroad. Central banks, especially in China, Hong Kong, and Taiwan, are diversifying out of the dollar into the euro. By the end of the year, the euro could make up 20% of their reserves, up from 10% in 2002.

The greatest worry for the dollar is that the U.S. will follow Japan into a slow-growth, deflationary spiral. There are startling similarities between the countries: a bubble that burst and intense competitive pressures from Chinese imports. The differences, however, are just as important. The U.S. financial system never froze, as it did in Japan, where banks were unable to get rid of bad debts and return to the business of making loans. U.S. corporations have savagely cut costs to boost profits. Japanese companies have not cut nearly as much, and their profits have been flat for years. Most important, the Fed has benefited from Japan's experience and is determined to get ahead of deflation. It is already acting by taking out insurance via rate cuts.

What should be done to stop a declining dollar from becoming a rout? Washington must broker a deal on a tax cut that stimulates growth now without building in huge budget deficits later. The European Central Bank, facing unemployment rates of 9% for Germany and France, should cut interest rates sharply and soon. That would close the rate gap, generate growth, and help U.S. exports. Longer term, Europe and Japan must find the political courage to reform their economies and get them growing again. The U.S. can no longer afford to be the only locomotive in the world economy.

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