December 10, 2003

Two years ago, my family visited Madrid when the euro cost $0.84. A year ago, the dollar and euro were the same. Today, it costs $1.22 dollars to buy one euro.

The long term reason for why one currency should be exchanged for a different price relative to another currency, differences in relative inflation, have not been apparent over this time. . Instead, the dollar cost of spending a day in Spain has increased by 45 percent in only two years.

Not only are vacations becoming more expensive. So are all those goods produced in Europe and those parts of Asia where the dollar is allowed to fall freely. (Japan continually intervenes to blunt currency changes in a single direction while China continues to insist that its currency should remain at a fixed relationship to the dollar).

To some extent, these adjustments are necessary.

When the dollar was gradually rising in value during the 1990s, exports from the U.S. were growing more than twice as fast as the domestic economy. This growth abruptly stopped in April 2000 and domestic manufacturing employment began its long swoon.

Since April of 2000, exports have declined almost every month until June 2003. We have since observed a small bounce in our exports as the world's economy has begun recovering from a recession. The dollar's weakness also has contributed to this export improvement.

In the meantime, imported goods had become so inexpensive (and are continuing to be low priced for China, and to a lesser extent, Japan) that imports have been swelling. Higher oil prices and our continuously growing consumption of that product have not helped either. (Oil imports are costing us more than a half billion dollars a day to feed our SUVs and other energy needs).

Currency gyrations are not unusual over a cycle. However, two factors have especially accentuated this currency volatility.

After 9/11, investors around the world sharply increased their assessment of how risky the world is. To partially shield their savings from further evil minded attacks, they moved large blocks of assets into the most liquid capital market in the world, the U.S.

In order to do so, they needed to buy dollars and then purchase dollar based assets. (Those very low long term interest rates and the rapid rebound in stock values were partially generated by this inflow of international capital.)

With the world economies rebounding, those investors are beginning to find alternatives to U.S. capital markets. They also are disappointed with the euros, yen, pounds, and other currencies that their investments can command as they are converted back into local currencies.

In short, 9/11 led to increased dollar values that had no relationship to prevailing economic conditions. Now that international capital is going home, our dollar is falling sharply.

The second problem is the rapid growth in trade importance of a country (China) that uses the dollar as a benchmark for its own currency. Eventually, China will receive so much currency for its goods that it will be forced to alter its currency position. Otherwise, the capital flows will launch a speculative surge in the value of real assets in China.

Already, housing subdivisions outside of Beijing and Shanghai have houses priced near those in our more desirable suburbs. (Remember, the average purchasing power earned per household in the Chinese rice region is less than $2 per day). Chinese stocks have increased by more than 100 percent in value this year alone.

Until some Asian currencies are realigned and until some of that fright capital returns home, leading to more stable relationships between the dollar and other currencies adjusted for inflation differentials, what does the weak dollar mean.

We already talked about how expensive travel abroad is becoming. (Travel here, by contrast, is becoming cheaper.) Also, higher interest rates and slower stock price appreciation should follow from the outflow of international capital.

On the other hand, the erosion of manufacturing jobs should end soon. Our exports should again become a source of economic growth. However, exported goods may be earning more dollars than goods produced for the domestic market. This might lead to reduced production for domestic use until prices have increased here.

Lest some policy wonk think that a falling dollar is a good thing, other countries could try to solve their unemployment problems by cutting the value of their currencies. That kind of effort in the 1930s led to economic disaster. Also, goods we need, such as oil, might rise in dollars as producers try to preserve their European or Asian purchasing power from their production. Inflation could soon become apparent again.

As with most economic conditions, stable growth rather than volatile activity is desirable. The dollar today is not exhibiting that more desirable condition.


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