The rip-roaring stock market wasn't the only bubble that ballooned to unsustainable levels in the 1990s. The U.S. dollar did, too. Enamored of high growth rates, and a world-beating stock market, foreign investors poured money into the U.S., snapping up U.S. companies and equities. The influx of foreign funds drove the dollar inexorably higher, and with it, the trade deficit, as cheaply priced imports flooded the country and more pricey U.S. exports abroad sagged.
Now, the day of reckoning looks to have finally arrived. A dollar drop that began early last year has picked up speed. The greenback has suffered its biggest drop against the euro, losing 23% since Jan., 2002, 7% since mid-March alone. Although less severe, the dollar has also tumbled 12% against the yen and 8% against a broader basket of currencies of America's trading partners over the last 17 months. And further declines are in store, experts say.
Unlike the bursting of the stock market bubble, however, the dollar's drop is good news, on the whole, for the U.S. economy. Sure, over the short term, it will raise the cost of imports into the U.S. and act as a temporary tax on consumers. Rising job worries are already hampering spending: Excluding autos, retail sales dropped an unexpectedly sharp 0.9% in April, according to the Commerce Dept.
Still, a rise in import prices will have a silver lining since it helps stave off the risks of deflation. Longer term, the weaker dollar should help put a dent in the trade deficit, which soared 8% in March, to $43.5 billion, the second-highest monthly total ever. Just as important, the dollar downdraft is already having a salutary effect on profits -- and the stock market -- by raising the overseas earnings of Corporate America. In the last few days alone, a string of companies, from Wal-Mart Stores (WMT ) and Procter & Gamble (PG ) to farm-equipment maker Deere (DE ) have joined the parade of companies reporting sharply higher foreign sales and earnings thanks to dollar-induced gains.
What's more, while the dollar's drop is causing deep pain for European, Japanese, and many other foreign exporters right now, eventually, it could be a net plus for the global economy if America's trading partners respond by cutting interest rates or loosening fiscal policy. Such steps would keep their currencies from rising much more against the dollar while stimulating their domestic growth. The result: worldwide economic expansion -- a kind of "competitive reflation" -- and a move away from the global economy's dangerous dependence on the U.S. for virtually all of its growth. "What we want in a deflationary environment is for all the central banks to assume a little bit of the burden" of spurring growth, says University of California at Berkeley economist Barry Eichengreen.
Of course, there's always the risk that the dollar decline could turn into a rout, with skittish foreign investors yanking money out of U.S. stock and bond markets, sending Wall Street plunging and interest rates skyrocketing. But so far, "We haven't seen any panic," says David Gilmore of Foreign Exchange Analytics. Indeed, as the dollar has dropped in recent weeks, both the stock and bond markets have risen strongly. While foreign investors are more nervous about new purchases of U.S. assets, they aren't selling off the stocks and bonds they have already bought. What seems to be happening, says former Federal Reserve official Edwin M. (Ted) Truman, is that foreign investors are keeping their money in U.S. stocks and bonds but hedging some of their exposure to the dollar by selling green- backs in the global currency market.
In some sense, the dollar's decline couldn't come at a more opportune time for the U.S. economy. Normally, a fall in the currency would be a concern because it would push up inflation, forcing the Fed to raise interest rates in response. But now, that's not the case because there's so much slack in the economy, with manufacturing companies operating at just 73% of capacity, a four-decade low. Indeed, as Fed policymakers signaled on May 6, they're worried about deflation -- a broad decline in prices that would wreck corporate profits, crash the stock market, and drag down the economy.
It was that signal -- and with it the implicit promise to keep interest rates low for an extended period -- that helped kick off the dollar's latest slide. Treasury Secretary John W. Snow gave it another push on May 11, when comments he made on TV were interpreted by the markets as lukewarm support for a strong dollar. Yet as far as the Fed and many in the Administration are concerned, the dollar's fall is a welcome tonic for the economy.
It's certainly good news for much of Corporate America, especially multinational companies. About a quarter of the sales of companies in the Standard & Poor's 500 come from their foreign units, estimates Merrill Lynch (MER ) & Co. The biggest reason for the immediate profit gains that many are starting to see isn't rising exports or better protection from cheap imports but simply from translating foreign earnings from more valuable foreign currencies into dollars. Of course, some sectors stand to do better than others. The biggest winners from a typical dollar decline are suppliers of consumer staples, energy, materials, and technology, while laggards tend to be financial services, utilities, and telecom, Merrill says.
Better results are already showing for U.S. multinationals such as McDonald's (MCD ) Corp., which reported on May 13 that its sales in Europe rose 19% in April. Most of that was the result of foreign-currency translation, not because the Oak Brook (Ill.) giant sold more burgers and fries in Europe.
With higher profits have come an improved stock market and increased investor wealth -- another plus for the economy. Fatter corporate profits should also relieve some of the pressure on companies to slash costs to boost earnings.
Over time, manufacturers in a host of industries from steel to office machines should also enjoy improved pricing power as the weaker dollar forces foreign rivals to raise prices in the U.S. That's what U.S. carmakers are hoping. For Chrysler Group, "the very strong dollar we've had since about 1997 gave foreign manufacturers...a pricing advantage," says DaimlerChrysler (DCX ) economist Van Jolissaint in Auburn Hills, Mich. A weaker dollar "will help us -- if not today, then later this year and next year, because it will reduce the ability of foreign manufacturers to offer discounts."
U.S. exporters of consumer and capital goods should also benefit from a weaker currency. The dollar's fall will allow them to cut local currency prices and grab market share abroad without having to take a hit to their dollar-denominated earnings.
Indeed, while it will take some time to play out, a weaker dollar should help trim the record U.S. current account deficit -- the widest measure of trade. That, in turn, should boost U.S. economic growth. Last year, U.S. domestic demand grew 3%, but about a half-percentage point of that was effectively filled by foreign companies thanks to America's insatiable demand for imports. This year, the foreign-trade sector should again be a drag on growth, but less so than it was in 2002, says former International Monetary Fund chief economist Michael Mussa. In 2004, it should be a small plus for the economy as the trade deficit finally starts to turn down.
Even with the steep decline of the dollar, though, not all import prices are headed higher -- and not all of the U.S.'s trade problems will be resolved. In part, that's because the dollar's fall has been uneven and mostly concentrated against the euro. Asian nations have acted to prevent their currencies from appreciating against the greenback. Japan sold $20.5 billion worth of yen in the first quarter in a move that limited the dollar's slide. And China, whose first-quarter trade surplus in goods with the U.S. soared from $7 billion in 1996 to $25 billion today -- giving it the world's biggest surplus with the U.S. -- has kept its carefully controlled currency steady against the dollar. That means there's no pressure on China to raise the prices of its exports. And if those prices don't rise, there's no reason to believe U.S. buyers will cut back on their purchases of Chinese goods or that the trade surplus will diminish.
Europe, on the other hand, is suffering the brunt of the dollar's fall. So far, European policymakers have reacted with equanimity to the euro's steep rise. Wim Duisenberg, president of European Central Bank, says the euro's strength is not yet a real concern. But it's a big worry for European companies, which are urging the ECB to cut interest rates.
That would be welcome in Washington. The Administration has been pestering America's trading partners to do more to boost global growth. It is also privately putting pressure on Beijing to allow its currency to float upward against the dollar in order to rein in surpluses. But that strategy is unlikely to bear fruit anytime soon, especially since the spread of SARS threatens to slow China's economic growth substantially.
Letting the air out of a bubble is never easy. There's always the risk that too much will come shooting out too fast. But in the case of the deflating dollar, so far, so good.
By Rich Miller in Washington and Peter Coy in New York, with Christine Tierney in Detroit, David Fairlamb in Frankfurt, and bureau reports