Commentaries: The Case for a Falling Dollar
Judging by the initial reaction of global financial markets, the call by the U.S. and its Group of Seven partners for more flexible currency rates was a disaster. Stock markets from Tokyo to New York nosedived on Sept. 22 as investors took fright at the dollar's fall after the G-7 meeting in Dubai.
Hold on. From a longer-term standpoint, the G-7 agreement -- and the weaker dollar it has already helped bring about -- is good for the U.S. and world economy. Provided it doesn't turn into a rout, the dollar's drop should spur U.S. economic growth and help bring down the bulging trade deficit by making U.S. exporters more competitive on world markets. It should also put any lingering fears of deflation to rest by raising prices of imports, giving hard-pressed U.S. manufacturers sorely needed pricing power. What's more, by helping to narrow the trade gap, the G-7 pact can head off mounting protectionist pressures in Congress, including a call by some members for tariffs that could prompt trade wars.
Despite a lot of loose chatter in the currency markets, the G-7 agreement is not a replay of the 1985 Plaza Accord, in which the U.S. and its allies agreed to sell the dollar aggressively to drive down its value. In some ways, the latest agreement is just the opposite. The G-7, led by U.S. Treasury Secretary John W. Snow, wants the markets -- not governments -- mainly to determine exchange rates. That's hard to argue with, given the history of official attempts to manage currencies. Remember then-Treasury Secretary James Baker's ham-handed management of the dollar in 1987 that led to the Oct. 19 stock-market crash? And what about the Asian Tigers' efforts to peg their currencies to the dollar that led to a region-wide crisis a decade later?
Still, the G-7's advocacy of more flexible exchange rates is tantamount to acceptance of a weaker dollar. Why? Because the countries that are trying to manage exchange rates -- Japan and other export-driven economies of Asia -- are massively intervening in the markets to keep the dollar high against their own currencies. China, which has the biggest trade surplus with the U.S., has pegged its currency rigidly at 8.3 yuan to the dollar since 1994.
During the go-go years of the late 1990s, a strong dollar was in the U.S. interest. Cheap imports helped keep inflation down and fill demand from consumers that U.S. companies couldn't meet because they were already running their plants flat-out. Now, the situation is reversed. Inflation is virtually nonexistent: Excluding volatile food and energy costs, consumer prices have risen just 1.3% over the past year. Indeed, the Federal Reserve is worried about deflation, not inflation. And U.S. factories are running at three-quarters of capacity, a 40-year low. A weaker dollar would give hard-pressed U.S. manufacturers some relief from low-priced Asian imports, especially from China. And by boosting U.S. exports, it would also give a welcome fillip to U.S. growth. William Dudley, chief economist at Goldman, Sachs & Co., says a 10% dollar drop would boost growth by about a half percentage point in a year.
Indeed, thanks to the gradual decline of the dollar that started in February, 2001, U.S. exports are already on the rise and in July hit their highest level in two years. Much of the U.S. gain abroad has come at the expense of European companies, courtesy of a 35% drop of the dollar vs. the euro. If Asian nations allow their currencies to appreciate more against the dollar, that would spread the pain that would accompany the reduction in the U.S. trade deficit. If it also spurred those countries to cut interest rates and ease fiscal policy to boost demand at home to make up for the lost exports, so much the better.
One possible downside: A shift in Asian currency policy could lead to higher interest rates in the U.S. Japan, China, and other Asian nations invest in U.S. Treasury securities, using the dollars they buy to support the greenback. The yield on the key 10-year Treasury note ticked up on Sept. 22 on expectations of reduced Asian purchases.
But the impact of any such cutback is likely to be muted by the Fed's determination to keep short-term interest rates super-low to ward off even the remote risk of deflation. What's more, it's not in Japan's or China's interest to force U.S. rates sharply higher by dumping Treasuries. The last thing they want to do is hurt the economy of their largest export market.
Global trade is out of whack. After the collapse of trade talks in Cancún, Mexico, flexible exchange rates are probably the best tool big economies have to try to right the balance. In Dubai, the G-7 took an important step toward putting the world economy on a firmer footing. They should be applauded, not jeered.
By Rich Miller