Commentaries: The Case against the Falling Dollar

It'll scare off foreign investors -- and do zilch to boost inefficient industries

For 8 years, Democratic and Republican Presidents alike have mostly followed a strong dollar policy. With manufacturing jobs draining out of the U.S. like sand from an hourglass, the Bush Administration has broken with that tradition by encouraging the dollar to fall against other currencies, particular those of China, Japan, and other Asian exporters. The hope is that a weaker dollar, by making imports more expensive at home and U.S. exports cheaper abroad, will close the trade gap and stop jobs from going overseas.

But a falling dollar could have serious negative consequences without actually fixing the problems that are causing the trade deficit to widen. For starters, a weaker currency could scare off foreign investors, depressing the stock market and sending interest rates soaring. In the short run, it will also force consumers to pay more for imports and drain off money they could have used for something else, thus dampening growth. What's more, currency manipulations will do nothing to fix the fundamental problem: Much of U.S. manufacturing has simply not been innovating and boosting productivity fast enough to compete effectively in the global marketplace.

Consider first the impact of a falling dollar on foreign investors. The U.S. depends on an enormous flow of capital into the country to fund everything from business investment to home construction to the government budget gap. Over the last year, for example, the U.S. has absorbed roughly $800 billion in foreign capital, with most of that going into corporate bonds, Treasury debt, and mortgage-backed securities.

Any drop in the dollar big enough to cut the trade deficit significantly -- say, 15% -- would also greatly reduce or eliminate the returns for European or Asian investors who put their money into U.S. securities. Moreover, the prospect of further declines in the dollar would encourage foreign investors to start pulling out their funds from the U.S. stock and bond markets. The outcome could be a spike in interest rates, much greater difficulty in raising money, and a squeeze on domestic growth.

What about the supposed benefit of reduced imports and increased exports? That certainly will happen eventually, but it takes time for exporters to gear up and for retailers to shift from foreign suppliers to domestic alternatives -- if, indeed, any exist for many products. As a result, in the short run, retailers will face higher costs when the dollar declines, which they will pass on to consumers as higher prices. That leaves less money for Americans to spend on domestic goods and services. In effect, higher import prices serve as a giant tax, hitting the U.S. economy just as it finally begins to recover.

Finally, and perhaps most important, the focus on the strong dollar as the cause of the trade deficit may miss the point. The trade-weighted level of the dollar is about where it was at the middle of 1998. The trade deficit today, however, amounts to almost 5% of gross domestic product, compared with just under 2% in 1997.

There are several reasons the trade deficit has expanded so much, including the consistent ability of the U.S. to grow faster than Europe and Japan. But surprisingly, one critical factor is that, outside of high tech, productivity growth in much of manufacturing has been a lot weaker than people realize. According to just-released data from the Bureau of Labor Statistics, fully half of the 86 manufacturing industries tracked by the government had annual productivity growth of 2% or less between 1995 and 2001. One-third had productivity growth of less than 1% annually.

Without strong productivity growth, it's hard for domestic factories in these industries to hold down costs and compete effectively in global markets. Moreover, the government's figures also suggest a lack of innovation in much of manufacturing. That makes outsourcing much easier, since it is a lot simpler to set up factories abroad in industries where the production techniques are well understood and not changing very quickly.

The BLS data show, for example, that output per hour in the electrical equipment industry rose at only 0.5% per year from 1995 to 2001. Not coincidentally, imports of generators, transformers, and other electrical equipment from China alone totaled more than $4.3 billion in 2002, vs. $2.8 billion on 1998. Other industries with low productivity growth are domestic producers of industrial and construction machinery, household furniture, audio and video equipment, and magnetic media such as videotapes and diskettes -- and all have made significant shifts of production overseas as well.

Expecting a lower dollar to boost puny productivity is like putting a Band-Aid on an amputated limb. Either no further innovation in these industries is possible -- in which case they will inevitably move to low-cost countries -- or U.S. manufacturers are simply falling down on the job. Either way, a weaker greenback won't help.

By Michael J. Mandel

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