The Dollar Dance

The recent acceleration in the dollar's decline, along with heightened anxiety in Europe and Japan over the rise in their currencies, has prompted President Bush to reaffirm the admin-istration's support for a "strong dollar."

Yet the strong-dollar mantra has clearly outlived its usefulness and lacks credibility.

The U.S. current account deficit is climbing toward a postwar high of $650 billion (5.5 per-cent of gross domestic product), with many analysts projecting even larger deficits in future years. Almost everyone-including the Bush administration-recognizes that trying to reduce the U.S. external deficit to a more sustainable level (say, half the size of the present deficit) without the aid of a significant real depreciation of the dollar would slow the economy too much.

More than half of that needed dollar depreciation has already taken place without any noticeable U.S. policy action to prevent it. Nor has the Treasury Department signaled that the dollar decline has gone far enough. Quite the contrary.

The Treasury has been encouraging Asian countries-especially China-to permit greater flexibility in their exchange rate policies, hoping this would lead to meaningful Asian currency appreciation against the dollar. And it has rejected proposals for intervening in exchange markets (with Europe and Japan) to slow the fall of the dollar. In deed if not in word, the Treasury has sent the message that a strong dollar is not currently in the U.S. national interest. And the Bush administration is right to think so.

But casting aside the strong-dollar mantra without specifying a replacement carries risks. It could be interpreted by markets and our trading partners as an indication of "benign neglect," or even of the United States seeking an unfair competitive advantage.

This, in turn, could result in a disorderly decline in the dollar and increased trade frictions. And if there were an unwillingness to reduce U.S. spending to make room for the switch in demand toward U.S. products that would be induced by a much lower dollar, the outcome could well be strong inflationary pressures, very high U.S. interest rates and a hard landing for the U.S. economy

At the same time, Europe and Japan are already talking about the brutality of recent currency movements and are reportedly discussing the pros and cons of joint intervention operations without U.S. participation.

The answer is to simply say that the United States favors a dollar that is consistent with sound economic fundamentals at home and abroad. The advantages of such a "fundamen-tally sound" dollar policy lie both in what it does suggest and what it doesn't.

It does suggest that the dollar can at times be too strong, just as at other times it can be too weak. It also holds out the possibility-potentially important in discouraging a free-fall of the dollar-that the United States may be prepared to cooperate with its major trading partners to influence the value of the dollar when they agree that the dollar has departed markedly in either direction from sound economic fundamentals.

Favoring a fundamentally sound dollar does not imply that the United States believes it can devalue its way to prosperity. Or that the dollar should remain weak once our current-account problem is resolved. Or that in the future the United States will rely less on the markets in determining exchange rates.

Of course, no change in dollar rhetoric will generate an orderly decline of the dollar if the fundamental policies that have an impact on the U.S. current-account position are not improved. Paramount here is agreement in the administration and Congress on a credible medium-term plan for fiscal consolidation in the United States.

The administration's proposal to halve the fiscal deficit in four years hardly meets that standard. If one takes the Congressional Budget Office's figure for the federal budget deficit of $413 billion (3.6 percent of gross domestic product) for the 2004 fiscal year and adds to
it the extension of expiring tax cuts, reform of the alternative minimum tax and a realistic projection about the growth of total discretionary spending, the bottom line is no narrowing
of the budget gap in the medium term.

If the dollar is to decline further in a broad-based way, other currencies must go up in value. To induce wider Asian currency appreciation and to take some burden off the rapidly rising euro, the United States, Europe, Japan and the International Monetary Fund need to press China for an immediate 15 percent to 20 percent appreciation of the yuan. They should not be content with a vague Chinese pledge to introduce greater currency flexibility some time down the road.

The European Central Bank can help spur faster domestic demand growth in Europe by being cautious on future interest rate increases. Japan can contribute by continuing easy money policies and structural reforms and by not resuming large-scale currency intervention to weaken the yen.