May 1, 1995
"The Dollar is Just Down, It's Not Dead"
San Jose Mercury News
By Timothy Taylor
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TWO MYTHS about the U.S. dollar have received far too much currency lately. One is that the U.S. dollar has fallen perilously these last few months. The other is that the U.S. government or the Federal Reserve could easily set a more desirable exchange rate.

News stories about the falling dollar have tended to focus on hitting all- time lows against the Japanese yen and German mark. At the start of 1995, a dollar bought 100 yen and 1.55 marks. Now, it's more like 82 yen and 1.37 marks.

But comparisons with just two countries are insufficient to make overall judgments about the exchange rate. After all, Japan and Germany combine for only about 20 percent of U.S. foreign trade.

Even as the dollar weakened against the yen and mark, it held steady against the Canadian dollar and grew much stronger against the Mexican peso, as the peso collapsed. Those two countries combine to represent more than 25 percent of U.S. foreign trade.

To make an overall statement about the foreign exchange value of the dollar, one must average together the currency changes for major U.S. trading partners. Economists at the Federal Reserve do this, constructing an index that weights the exchange rate of each particular country according to how much trade it does with the United States. According to Fed calculations, the dollar is down only about 6 percent since December.

Larger declines have occurred in recent years. From 1985 to 1986, the overall dollar exchange rate fell by 22 percent. From 1986 to 1987, it fell another 12 percent.

In the eight years since then, the dollar has bounced up and down within a relatively narrow range. It was near the top of that range early in 1994 -- almost as high as it was in 1989. Now, the exchange rate is at the low end of that range, as it was in 1992.

The U.S. dollar has fallen lately, but not by an incredible or unprecedented amount. Any predictions of how the falling dollar will lead to sharply higher inflation or substantial reductions in the U.S. trade deficit should be treated with considerable skepticism.

The simplest explanation for the dollar's situation is a speculative mood feeding on itself. When some currency traders believe the dollar is likely to fall, they start selling it, and their sales help to drive the dollar down and fulfill their original gloomy prediction. In turn, this encourages other traders to sell off the currency, which brings a still larger decline.

More than a trillion dollars a day is traded on the notoriously volatile currency markets. As currency markets chase their own tails, whiplash movements, up and down, are common.

Governments have two tools they could use to raise their exchange rates in the face of the speculators, but one can be very costly, and the other can have vicious side-effects.

In one approach, the government buys its own currency directly, thus offsetting the sales of pessimistic currency traders. The problem here is that if the value of the currency does eventually fall, then the government bought something (its own currency) which suddenly becomes worth a lot less.

For example, the Bank of England tried to sustain the value of the pound in the fall of 1992 by buying pounds. But the pound eventually fell anyway -- and the Bank of England lost $7 billion in a single afternoon as a result. That $7 billion was pure profit for the currency traders who had bet on the decline of the pound.

Alternatively, a government might raise its interest rates to make investing in its currency more attractive, and dissuade some currency traders who would otherwise sell it. But higher interest rates also slow down business investment and consumer purchases of homes and cars, and threaten to drag an economy into recession.

In extreme cases, when a currency is collapsing, a government may have to try everything: buying its own currency, raising interest rates, and seizing any reform that might build investor confidence. But the United States is simply enduring the slings and arrows of the currency markets, which are annoying and painful, but don't last forever. At least for now, the Clinton administration's benign neglect of the dollar is the right policy.

There are several ways of predicting where exchange rates will end up in the medium run. One method looks at the purchasing power of different currencies, measured in terms of internationally traded goods. Another estimates what exchange rate would be stable, given the flows of imports, exports, and investments between countries.

Such studies generally show that the exchange rate of the dollar is somewhat too low at present. If these studies are correct, then many of the currency traders who are dumping the dollar today will live to regret it.

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