Weak Dollar is Price of Cutting Trade Deficit

The world has long urged America to get its trade deficit under control. Now might be the time. And the rest of the world is already wishing for the good old days of US profligacy.

Economists are generally agreed that if the United States is to bring its trade deficit down from over 6.5% of GDP to a sustainable 2%, the dollar will have to fall by about 40%. That means that Britain’s exporters — America is their biggest market, worth £31 billion — will find themselves trying to persuade Americans that the Jaguar that has been selling for, say, $80,000 is still a good buy at $133,000, and that a bottle of 18-year-old Macallan whisky that now retails in America for about $140 is worth sipping even at a price of $230.

German exporters will also find life unpleasant. The $100,000 Mercedes would cost $166,000. Italy might find that American tourists willing to pay, say, $200 for a hotel room in Venice, would decide that $320 is so stiff that a vacation in Las Vegas, with its faux canals, will have to do. And the French, vocal critics of the US trade deficit, are now calling for “collective vigilance” to stem the fall of the dollar, which is making it difficult for their winemakers to sell in America.

Few believe that the dollar will hit such export-killing, import-spurring levels. To make a more realistic guess at the long-term direction of the greenback, consider what has enabled it to stay so high for so long in spite of America’s huge trade deficit. First was the robustness of the American economy. While Europe wallowed in the consequences of its unreformed labour and product markets, America barrelled ahead. Now the situation is reversed.

In America, the recent decline of the housing market, weaker sales of durable goods, and a downturn in consumer confidence forced the White House to lower its growth forecast for 2007. Meanwhile, the German economy is showing signs of life, and Britain continues to move ahead. So the direction of the divergence that enabled the dollar to remain strong might, only might, be shifting. If the EU grows more rapidly than America, investors will be attracted away from dollar-denominated assets and towards investments in Euroland and Britain.

That trend is accelerated by investors’ expectations on interest rates. The dollar was long buoyed by the Federal Reserve Board’s upward ratcheting of interest rates, while Europe’s central bankers by and large held the line. Now the situation might be reversed. A significant number of investors expect the weakening American economy to force the Fed to lower interest rates in the spring, while the strength in Europe will force the European Central Bank to follow the Bank of England and raise rates before this year is out. Such a reversal increases the attractiveness of non-dollar assets, and weakens the dollar.

Then there is China. China has supported its job-creating export industries by buying dollars and dollar-denominated IOUs in order to keep the yuan undervalued. Treasury secretary Henry Paulson and Fed chairman Ben Bernanke will lead a delegation of cabinet members to China later this month to urge the Chinese to allow their currency to appreciate. The Chinese will listen with greater attention than in the past because they want to give Paulson some weapons with which to cool the protectionist sentiment they increasingly fear now that the Democrats control the Congress. If America gets what it has been wishing for, China will weaken the dollar by slowing its purchases of the American currency, and allowing its own currency to rise.

Finally, there is oil. Part of the dollar’s strength in the face of the American trade deficit stemmed from the willingness of the Middle East’s oil producers to mark the dollars flowing to them from American motorists “return to sender”. No longer. Arab oil producers, worried about the safety of their investments in a hostile United States, have turned to domestic infrastructure projects, and to Europe and China as outlets for their increasing riches.

As the dollar sinks and sterling soars, Britons of a certain age might spy a double irony. First, the timing: it is 39 years ago almost to the day that British prime minister Harold Wilson announced a devaluation of the pound from $2.80 to $2.40. Second, the level: $2.80, believed by Wilson to be the cause of Britain’s non-competitiveness, is below the level to which economists think the dollar must fall if the American trade deficit is to be reduced to sustainable levels.

Wilson produced much hilarity when he attempted to reasssure voters that the devaluation does not mean that “the pound here ... in your pocket ... has been devalued”. Don’t expect President George Bush to take to television to assure Americans that the devaluation of their currency will have no effect. They know better, as they confront the rising cost of imported goods and foreign travel.

More important, Bush might not need to make such an apology. The dollar’s drop won’t become a plunge if the Fed’s fear of inflation, reiterated last week by Bernanke, prevents it from lowering rates. It won’t collapse if China decides to protect the value of its $1,000 billion in foreign reserves by continuing to shore up the dollar. And the dollar might merely glide down rather than crash if the economy resumes its trend rate of growth, while Europe slows down. Both are likely, as rising incomes and profits shore up the American economy, and the large tax increases in store for German consumers in the new year drag Europe down.

So if you think the dollar is due to collapse, back your guess with a modest punt if you like. But don’t bet the family farm on it.

This article originally appeared in the Sunday Times.