A Lot Of Drama, Just A Little Danger

The global economy can handle the dollar's divethough a currency crash is not out of the question

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Exchange rates are the circus act of the global economy. The dollar, the pound, the euro, and other currencies take turns soaring and diving, as investors applaud or gasp. But except for the rare—but not impossible—currency crash, the gyrations of the exchange markets have less long-term economic impact than they might first appear to have.

Consider the latest movements of the U.S. dollar. Driven by the housing bust and the huge trade deficit, the greenback has plunged over the past year against such currencies as the euro, the Canadian dollar, the British pound, the Brazilian real, and the Indian rupee. That's left the dollar at a 26-year low against the pound, for example.

The currency shifts have made imports from these countries more expensive and U.S. exports more attractive, just as economics predicts. They've also boosted returns for U.S. investors on many non-U.S. stock markets.

Yet what's remarkable is how little has changed. The U.S. trade deficit with the European Union, including Britain, has come down, but it's still running at an annual rate of $100 billion to $110 billion, despite the dollar's fall. The annual deficit with Canada, too, is still about $65 billion. And most global corporations have coped well with changing exchange rates, using hedging strategies to blunt the impact and shifting production among the many countries they operate in. For example, General Electric Co. (GE ) noted in its 2006 annual report that a 10% shift in exchange rates would have an "inconsequential effect" on its 2007 earnings.


Most market watchers do not expect the buck to drop much further against European currencies, even with all the housing market turmoil. "A lot of bad news is priced into the dollar already," says Richard Franulovich, a senior currency strategist at Westpac Banking Corp. (WBK ) in New York. Indeed, Robert M. Sinche, head of currency strategy for Bank of America Corp., (BAC ) believes that the dollar will rise 3% to 5% against the major European currencies over the next year.

The reality is that business executives and investors know that big swings up and down are a fact of life in the foreign exchange market. Six years ago the pound and the Canadian dollar were flat on their backs, and the dollar was standing tall. And the euro, which hit an all-time high of $1.38 on July 20, was worth only 83 cents in 2000, making European politicians and business leaders wonder why they had worked so hard to create a single currency that no one seemed to want.

Looking back over 20 years, the dollar has flipped and flopped around, without losing much value in the end. According to the Federal Reserve, the dollar is about 22% weaker, compared with other major currencies, than it was in 1987. That translates into a surprisingly small decline of 1% per year.

That's not to minimize the impact of currency swings on small businesses and individuals, who can't take advantage of global financial markets like the big boys can. Still, the key question is whether the current decline in the dollar will turn into a panicky slide. The odds are relatively low, says Brad Setser, senior economist at RGE Monitor, "so long as the world's central banks are willing to buy dollars when nobody else is willing to do so." Setser estimates that central banks have been adding roughly $200 billion in dollars to their reserves each quarter, roughly equal to the U.S. trade deficit.

All bets are off, though, if the problems in the housing sector turn out to be worse than expected and if the growth rate of productivity slows. Then foreign investors will start fleeing the dollar, and even massive purchases of U.S. currency by central banks around the world won't provide an adequate safety net.

For now, though? Just sit back and enjoy the show.

By Michael Mandel, with Peter Coy, in New York

— With assistance by Peter Coy

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