Pressure is building on Treasury Secretary Paul O'Neill to do something about the soaring value of the dollar. Although a strong dollar is good for consumers, because it makes foreign goods cheaper, it is harmful to exporters, by making U.S. goods more expensive on world markets. The result is a widening trade deficit, as imports increase while exports stagnate.
Manufacturers and farmers are especially sensitive to changes in the value of the dollar, as they must compete head-to-head on international markets with producers of essentially the same products. A barrel of corn, after all, is pretty much the same everywhere, so purchasers buy almost entirely based on price. If they have to spend more lira, yen or rubles to buy corn, even if it's only because the dollar has risen against their currency, then they are going to buy it someplace where it is cheaper.
This is a source of great frustration to many American businesses, because in many cases they are the world's most efficient producers. But their advantage in terms of productivity has been offset by forces beyond their control, namely exchange rates. That is why the National Association of Manufacturers and other business groups are pressuring O'Neill to intervene in financial markets to bring the dollar down against foreign currencies.
The dollar has risen pretty much steadily against most major currencies since the Mexican financial crisis in 1995. At that time, the Treasury was forced spend large sums from its Exchange Stabilization Fund to help support the peso. This had the effect of driving the dollar down vis-a-vis other currencies. Subsequently, however, the dollar moved sharply upward, with just a slight dip for the Asian financial crisis in 1998.
In 1995, $1 would buy 94 yen. Today, it will buy 122 yen. One dollar would have bought $1.37 worth of Canadian goods in 1995. Today, $1 will buy $1.52 worth of Canadian goods. The same story can be repeated almost across the board. The Federal Reserve's index of the dollar's value against major currencies, adjusted for inflation and weighted by trade, shows an increase of 39 percent in the last 6 years. This means that prices of U.S. goods would have to fall by 39 percent in real terms just to stay competitive on international markets.
Considering that the U.S. trade and current account deficits have risen to record levels, this is a remarkable performance. In theory, such deficits should cause a currency to weaken, thus bringing about an automatic readjustment. Yet the trade deficit just keeps getting bigger. Last year, the United States imported $449 billion more goods than it exported. Taking services into account improved the figure somewhat, to a deficit of just $368 billion. But because foreign-owned companies in the United States earned more than U.S.-owned companies abroad, the current account deficit hit $435 billion, four times larger than its 1995 level.
The reason why the dollar has continued to rise in the face of large deficits is because there is a scarcity of dollars in the world economy. Demand for dollars has outstripped their supply, thus causing the value of the dollar to rise. Thus the rising value of the dollar is very much related to Federal Reserve policy. When it tightens monetary policy in order to fight inflation, it inevitably strengthens the dollar, especially when other countries are following a looser monetary policy.
As long as money remains tight, the dollar is going to stay strong, resulting in rising imports, increasing price and profit pressure on exporters, and a bigger trade deficit. At some point, this situation will become intolerable, if only for political reasons.
The United States faced a similar situation in 1985. It ended when Treasury Secretary James A. Baker engineered an international monetary agreement at the Plaza Hotel in New York in September of that year. The United States agreed to sell dollars from the Exchange Stabilization Fund and buy foreign currencies, while foreigners agreed to do the same. The result of this coordinated currency intervention was to bring the dollar down sharply, which improved the competitiveness of U.S. exports.
It took some years for the impact of a lower dollar to improve the trade balance, but by 1991 the trade deficit had fallen by more than half. This resulted mainly from stronger exports. Between 1987 and 1991, exports rose by two-thirds, while imports increased just 20 percent. Since imports are subtracted from the gross domestic product, while exports are added, this improvement in the trade balance contributed strongly to GDP growth.
Soon, O'Neill may emulate Secretary Baker and engineer a new international monetary deal to at least halt the dollar's rise. It may be just the sparkplug the economy needs to get moving again.
Chart data: Real Trade-Weighted Value of the Dollar
Year ---- Index
1981 ---- 100.0
1982 ---- 108.4
1983 ---- 109.9
1984 ---- 117.2
1985 ---- 121.1
1986 ---- 98.8
1987 ---- 88.4
1988 ---- 83.3
1989 ---- 87.4
1990 ---- 84.3
1991 ---- 82.6
1992 ---- 81.5
1993 ---- 84.2
1994 ---- 83.8
1995 ---- 79.9
1996 ---- 85.0
1997 ---- 92.3
1998 ---- 97.3
1999 ---- 96.7
2000 ---- 102.8
2001* ---- 111.1
Source: Federal Reserve