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--- Begin Message --- -Caveat Lector- JANUARY 31, 2003
BusinessWeek online
SOUND MONEY
By Christopher Farrell
The Dollar's Precarious Position
Its decline has given the U.S. economy a timely boost. But in the longer term, it could plummet -- particularly if a war in Iraq goes badly
The state of the economy is tepid. President Bush gave a perfunctory push to his $674 billion tax-cut plan during his State of the Union address, but it isn't generating much enthusiasm. Democrats have devised a number of counter proposals for stimulating the economy, all with little effect. The fiscal stimulus has been substantial over the past year, but it will take months before Washington can legislate another fiscal package to further support the economy.
In the meantime, a government policy of benign neglect is bringing much needed support to the economy -- at least in the short term. The dollar is down by more than 15% on a trade-weighted basis since last March. And the decline has accelerated over the past three months.
There are downsides to a weaker dollar. Overseas investors seem convinced that the U.S. is no longer the place to look for lush asset returns. Little wonder, considering the U.S. stock market just finished its third year of consecutive negative returns, with the prospect of another down year looming. Investors are getting out of dollars and snapping up Euros, partly because European interest rates are higher and partly because the Continent is perceived as a safe haven while the U.S. prepares for military action against Iraq.
SHORT-TERM BENEFITS
What's most worrisome is that war could turn the dollar decline into a rout, sending interest rates skyrocketing and equity prices plunging. Indeed, the day after Bush's speech the dollar recorded its eleventh drop in 12 days. The economy is extremely vulnerable to a dollar decline, since America has never been so dependent on foreign capital. The U.S. current-account deficit, the broadest measure of trade including investment flows, is the biggest in 200 years, according to economists at UBS Warburg. The risk that war may spark a run on the dollar is the largest macroeconomic threat to the economy.
To be fair, the U.S. economy is benefiting in the short term from the dollar's weakness. A lower dollar should boost the international competitiveness of America's manufacturing, mining, and similar industries. The sector could use some relief. "Job loss in these 'tradeable good' sectors has accounted for 154% of total job shrinkage since the high water mark in U.S. employment," says James Griffin, economic consultant and portfolio advisor at Aeltus Investment Management.
For the record, Washington has favored a strong dollar policy for years, especially under Treasury Secretary Robert Rubin during the Clinton Administration. A strong dollar brought about a lot of economic benefits in the '90s. For instance, a stable currency and healthy economy lured buckets of foreign investment money into the U.S. The high value of the dollar made imports cheaper, a critical aid in the Federal Reserve's fight against inflation. John Snow, the Bush Administration's nominee for Treasury Secretary, came out strongly in favor of a robust dollar in recent testimony before the Senate Finance Committee. "A strong dollar is in the national interest," he said.
REMEMBER SUEZ
That continues to be the official, traditional Treasury line. But no one in Washington seems too worked up about the dollar's rather rapid depreciation this year. And besides the boost to manufacturing competitiveness, the greenback's decline has nudged other nations to ease monetary policies to keep their currencies from appreciating too quickly against the dollar.
Britain's experience during the Suez Crisis of 1956 is instructive. Despite a current account surplus, the value of Britain's currency was under speculative pressure. Traders were betting that Britain would abandon sterling parity with the dollar, which had been set at $2.80 in 1949. Egypt then nationalized the Suez Canal Company in July, seizing control from an international consortium.
Britain, together with France and Israel, intervened militarily to take back the canal. But the U.S. government didn't back the action. Neither did the U.N. Britain found itself in a full-fledged currency crisis: it quickly agreed to pull out of Suez to get needed financial support from the International Monetary Fund.
GATHERING GLOOM
Like all historical examples, the parallels are limited. Still, "the 'takeaway' from the Suez crisis is that unilateral political/military action can sometimes be compromised by global capital flows," says David Bowers, chief global investment strategist at Merrill Lynch. "It is one thing to attract capital to fund a private-sector, tech-inspired, capital-expenditure boom. It is quite another to fund increased military spending."
The White House would be well served to take note that the mood in the financial markets is dark. And nowhere is the tension greater than in the world's currency markets.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, on BusinessWeek Online
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