Prospects for the Dollar

The United States slaps tariffs on imported steel, and the European Union (EU) responds by threatening to do the same to goods made in states important to President Bush’s electoral prospects. The U.S. hits Canadian lumber imports with a 29 percent duty, and the Canadians respond with a 71 percent duty on American tomatoes. President Bush might not like it, but the mounting U.S. trade deficit is forcing him to appease certain angry constituencies. As he sees it, he has to destroy some trade in order to push his broader free trade agenda through Congress.

Americans persist in buying more from foreigners than they sell to them, piling up a huge trade deficit. This is good for consumers, since the lower-priced foreign goods raise their purchasing power and put a lid on the prices domestic producers can charge. But it isn’t so good for workers in the steel, textile, and other industries. They find their wages depressed or their jobs wiped out by the flood of goods from overseas.

So these workers, and their unions, and the industry associations representing many companies, last week trooped up to Congress to demand that the government make it easier to sell abroad, and more expensive to import foreign-made goods, by driving down the dollar. Some in Congress and in the administration are sympathetic. “We’re unwilling to continue to let other countries export their unemployment to the U.S.,” says Grant Aldonas, under-secretary of commerce for international trade. Administration officials are telling Japan and the EU to reform their own economies, eliminate labor and product market rigidities, lower taxes as Bush has done, and get their economies growing so that they can buy more goods from America and lower the U.S. trade deficit.

That deficit is now becoming something of a worry. For a long time America has offset its trade deficit by being so attractive to foreign investors that the excess dollars sent abroad have come back as investments in U.S. assets—shares, bonds, real estate, government securities. That demand for dollars by investors has prevented the dollar from falling, which it would otherwise have done as the trade deficit widened.

Not a bad thing, from the vantage point of the office of Federal Reserve Board chairman Alan Greenspan. The inflow of cheap foreign goods helps dampen inflation, and makes it easier for him to keep interest rates low so as to maintain the pace of a recovery that some observers, including Greenspan, see as still fragile. Greenspan does not want to add to CEOs’ reluctance to invest in new plant and equipment by raising interest rates—which puts him on the side of those who would not like to see a rapid and inflation-inducing decline in the dollar.

Unfortunately for him, three developments came to a head last week that suggest that the day of the strong dollar may be coming to an end. First, the mounting trade deficit has gotten the attention of investors around the world who are holding dollar assets. It is a rule of thumb that when a nation’s trade deficit hits about 5 percent of its GDP, its currency will fall in value. And America is headed to that dangerous territory.

Second, American companies are finding that the consumer won’t tolerate price increases. That, plus a post-Enron wave of more realistic profit calculations, is creating a profitless recovery, a lack of buoyancy in share prices. So foreigners have begun to look around the world for other places to put their money, which means they don’t want as many dollars as Americans are shipping abroad to pay for their imported cars and T-shirts.

The third factor increasing pressure on the dollar is American Treasury secretary Paul O’Neill. The markets believe that since the days of Clinton’s Treasury chief, Bob Rubin, America has had a “strong dollar” policy. But O’Neill refused to use the magic words “strong dollar” when he appeared before Congress last week, and instead confessed that finance ministers can’t affect the value of currencies except in the very short run. Investors, he said, will put their money in whatever country provides the best opportunities for profit—meaning they will buy the currency of that country to fund their investments.

This is what makes it so difficult to guess where the dollar is headed. The recent and, it seems, now completed slowdown in the U.S. economy did not dampen enthusiasm for foreign wares, and a robust recovery should make Americans send even more dollars overseas. Meanwhile, the Japanese economy remains in the doldrums, and the EU’s largest economy, Germany, shows no sign of perking up, making them poor markets for made-in-America goods. So America is likely to continue exporting a lot more than it imports.

Which means that the dollar will weaken—unless foreigners use the dollars earned in trade to invest in U.S. assets. But foreign investors, surveying the dreary landscape that is the U.S. market for shares, are showing less enthusiasm for American assets. If they continue to put their funds elsewhere, dollars will be in oversupply and their price will fall—gradually, if America is lucky, precipitously if the pessimists are right. That, say the gloom mongers, will unleash inflation, force the Fed to raise rates, and abort the fledgling recovery.

That scenario depends on a crucial assumption: that investors can find venues a lot more attractive than America. Japan? Not likely. Euroland? Perhaps, but not unless major reforms drive up productivity and scrap regulations that discourage investment, neither of which seems likely. Latin America? Argentina stands as a warning to those who are tempted by the apparent stability in countries other than Chile. Emerging economies? Attractive to investors with short memories, but not to others.

So the likeliest scenario is that investors will continue to find the U.S. a relatively attractive place, although perhaps a bit less so than in the past. That, combined with the continued propensity of Americans to buy more from abroad than they can sell overseas means that the dollar may well weaken. But a collapse just doesn’t seem likely.