Declining Dollar's Many Dangers

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The dollar is lower again against the euro Tuesday, so that one euro is now worth $1.13, a fresh four-year high for the European currency. The dollar has lost almost 19 percent of its value against the euro in the past year and 6 percent of its value against the Japanese Yen. It looks set to weaken further, posing dangers for the United States and the rest of the world.

There is a simple reason for the dollar’s fall. The United States has had a large deficit on current account (the broadest measure of trade, including services, like tourism, and dividends) for several years. The annual deficit in 2002 was its biggest ever, at half a trillion dollars. Close to 5 percent of U.S. gross domestic product. Capital inflows into the United States used to exceed the current account deficit and the “extra” demand for dollars tended to push its value up. But now that is no longer the case. Capital inflows are not sufficiently high to offset the current account deficit and the US currency is weakening.


It is a trend that poses dangers for the United States and for the whole world economy.

In the first place, the falling dollar might be seen as positive for the United States. U.S. companies’ output is made cheaper for foreign buyers, while foreign buyers themselves lose competitiveness in the American market. A weaker currency should help the United States to export more and will tend to reduce its imports as consumers in the United States find domestic produce cheaper relative to imported goods. The huge current account deficit should decrease. Greater balance will be achieved. This is how free currency movement can be a good thing.

Usually, however, a falling currency, also poses a threat, of higher inflation, because the cost of imported goods rises when the currency — the dollar, in this case — loses value. But, at present, inflation does not appear much of a danger to the U.S. economy. The annual consumer price inflation rate in the United States rose to 3 percent, reflecting the influence of higher oil prices prior to the Iraq war, but the so-called core inflation rate, which excludes volatile energy and food prices, is down to just 1.7 percent.

Statements made by U.S. Federal Reserve Bank officials suggest it is the threat of deflation, in which prices actually fall, that has been troubling them, more than the threat of inflation.

But the falling dollar does pose other dangers. The United States’ ability to grow in the past ten years despite the current account deficit has hinged on capital inflows. In the late 1990s huge amounts of foreign investment poured into the United States, some of it “direct,” purchasing companies or merging with them, some of it “portfolio,” placing money in stocks and bonds. The inflows helped to feed the boom in U.S. stocks and the economy that lasted until 2001.

Since then both stocks and the economy have faltered and foreign capital inflows have slumped. Yet it might be argued that the United States needs those inflows now more than ever. For a second deficit is emerging, a fiscal one, as President George W. Bush raises spending, primarily on defense, and cuts taxes. In the current 2003 fiscal year, which began last October, the deficit is officially projected at a little over $300 billion but seems more likely to be of the order of $400 billion. The deficits, fiscal and on current account, need financing. Foreign money is important to both.

But will foreign buyers be as keen to buy U.S. government securities, or corporate bonds or stocks if the dollar looks likely to fall further? For the Japanese or European buyer, any return on U.S. assets will be eroded if the dollar is plummeting against the Yen or the euro.

The risk this carries for the United States is that a lack of foreign buyers of Treasuries and other U.S. assets drives down the prices of bonds and stocks. Falling prices for Treasuries drive up their yield and push up other long-term interest rates. The U.S. housing market, which has benefited in the past two years from some of the lowest mortgage interest rates ever recorded, would be vulnerable. A final bastion of the U.S. economy could be undermined and recession would become likely.

Meanwhile, for the rest of the world, the falling dollar creates danger, too. It means, for example, that European and Japanese exports will be pricier in the United States. Growth in Germany and France, and even more, in export-dependent Japan, is going to be hurt.

And that, too, will have knock-on effects. If growth is lower in Europe and Japan, demand for commodities and goods worldwide will be affected. Commodity prices may weaken. The poorer countries of the world are particular victims of that.

And the United States, too, will not be unaffected. If European and Japanese growth proves weak because of a loss of exports to the United States, then demand for U.S. exports will not be buoyant, even if the declining dollar makes American products cheap.

The world will be paying a price for relying on the U.S. engine for too long. That engine has worked too hard to keep the U.S and the world economy humming. Its deficits are signs of that. They cannot be cut without pain being felt all around.

”’Ian Campbell is the chief economic correspondent for the United Press International and can be reached via email at”’