Strong Dollar, Weak Policy.

A harsh rebuttal to Bush Advisor Lawrence Lindsey's defense of a "strong dollar."

Lawrence B. Lindsey, President George W. Bush's chief economic adviser, affirmed and articulated in the March/April 2001 issue of The Internationlal Economy the new administration's endorsement of the "strong dollar" policy maintained by the Clinton administration since 1995. Secretary of the Treasury Paul O'Neill has reiterated the same position since experimenting briefly with an alternative formulation in February. Their doing so raises two fundamental questions: the substantive issue of whether a strong dollar promotes the national interests of the United States at this point in time and the meaning of the term "strong dollar."

A "strong dollar" has never been defined by the relevant officials and the mantra was indeed uttered both when the dollar fell to 80 to 1 against the yen in 1995 and when it soared to 145 to 1 against that same currency in 1998. Those same officials have always taken great care to avoid espousing a "stronger" dollar and never suggested that the currency should rise in value except when the formulation was first introduced in 1994. Nor did they do anything to strengthen it after their market intervention when it hit record lows in 1995. In fact, they sold dollars against the yen in 1998 and against the euro in 2000, all the while repeating the "strong dollar" rhetoric.

Hence there was never much substance to the "strong dollar" pronouncements. Nevertheless, their frequent utterances clearly comforted the currency markets and avoided the risk of embarrassment for Treasury officials. Thus, these pronouncements could be justified, pragmatically if not intellectually, during a period when an appreciating and even overvalued dollar in terms of the underlying international competitiveness of our economy, as reflected in the current account balance, was in the national interest of the United States.

The second half of the 1990's represented such a period. The economy boomed at a rate that clearly exceeded the growth of potential output. Unemployment fell to unanticipated lows, raising cost-push pressures. Inflation remained in check but there were widespread fears, as the economy continued to soar past all previous estimates of its "full employment" level, that price surges might be just around the corner. The Federal Reserve was under continuing pressure to tighten monetary policy (which Chairman Alan Greenspan and the Board, to their great credit, resisted far longer into the cycle than any of their predecessors would have dared).

Under these circumstances, a rising dollar and the growing current account deficits that it substantially exacerbated were useful safety valves. The dollar has certainly risen substantially: by 75 percent against the yen from its trough of 1995 to its peak of 1998 (by 50 percent to the level of June 2001), and by 70 percent against the DM and other key European currencies from 1995 until mid-2001. This currency appreciation directly reduced the prices of imports and, much more importantly, competing domestic products. The rising external imbalance, at the same time, provided the additional supply of goods and services that was essential to meet a domestic demand that was expanding much faster than domestic output. The commensurately large net inflow of foreign capital that both caused and financed the trade deficit helped to hold down interest rates and thus to spur investment to record levels.

The truly strong dollar and the sizable imbalances in the extemal sector were therefore essential ingredients in permitting the United States to achieve its "economic miracle" in the late 1990's. The rest of the world gained too: Booming U.S. growth provided a sorely needed locomotive for a sluggish global economy and was central to enabling Mexico, then East Asia, and then Brazil and the emerging market economies more generally to recover swiftly from the financial crises that plagued this period. It was no wonder that U.S. officials found it useful to reiterate the "strong dollar" mantra, despite its intellectual short-comings, and that their counterparts around the world were usually happy to let them do so despite the unsustainable imbalances that everyone knew were being created for the future.

The arrival of the Bush administration coincided with a fundamental reversal of the underlying economic situation in the United States. Growth plummeted by four to five percentage points and the economy avoided recession, as officially defined, only because of the abnormally high pace of growth during the previous four years. The equity markets and public confidence dropped sharply. Unemployment began to climb and will surely rise further. Any extant inflationary pressures are likely to recede. Short-term interest rates have come down dramatically as a result of aggressive easing by the Fed.

The case for a "strong dollar" has thus disappeared. There is no need for its anti-inflationary impetus. There is no need to promote even lower interest rates. The structural benefits for the United States from global use of the dollar cited by Dr. Lindsey, our ability to finance international transactions in our own currency and the financial gains from currency seigniorage, have continued for more than forty years during periods of acute dollar weakness as well as dollar strength.

The impact of the "strong dollar" has in fact become quite negative. The drag of the huge trade deficit on the economy now becomes significant and the National Association of Manufacturers has importuned the administration that "at current levels, the exchange value of the dollar is having a strong negative impact on manufacturing exports, production and employment." As unemployment rises, these conditions are bound to add to Congressional pressure for protectionist trade policies. They will clearly make it even harder, in the face of an anti-globalization backlash that has already stalemated our trade politics since 1994, for the administration to win authorization for the new liberalization that it is courageously seeking.

Even more ominously, maintenance of the "strong dollar" posture will steadily increase the risk of a precipitous freefall of the currency. Such a rapid depreciation, even of only 20-25 percent a la 1971-73, let alone 50 percent or more as in 1985-87, could ignite an acceleration of price pressures despite the economic slowdown and reverse the fall in interest rates that is so crucial for achieving sustainable recovery. The stock market could plunge anew, as it did when the dollar tanked in 1987, further weakening the economy.

The current account deficit is approaching $500 billion or 5 percent of GDP. This is unprecedented terrain for the United States; the sharp dollar declines of 1971-73, 1977-78, 1985-87, and 1994-95 came with the external deficit at far lower levels. (Note that the United States has faced such declines about once per decade.) In her comprehensive study, Is the U.S. Trade Deficit Sustainable? (IIE, 1999), Dr. Catherine L. Mann of the Institute for International Economics showed that OECD countries have typically had to correct their external balances when they hit 4 percent of GDP.

As a result of these imbalances, the United States must import about $2 billion of foreign capital every working day. Even a slight decline in that net inflow, let alone its cessation or reversal, would send the dollar tumbling and the economy reeling. The huge deficits come on top of a net international debtor position for the United States that now probably exceeds $2 trillion. Gross foreign holdings of dollar assets exceed $10 trillion and could easily produce enough selling to drive the dollar down sharply in any given time period.

These problems are further intensified by the tax cut passed by the Congress and signed by the President this past June. The resulting drop in the budget surplus, and thus net government saving, will lead to a further decline in our already low level of national saving unless there is a wholly unanticipated pickup in private saving. Our domestic investment will thus have to be financed increasingly by the rest of the world. This will require even larger net capital inflows and even larger current account deficits. The day of reckoning is brought ever closer.

It is stunning that Dr. Lindsey failed to even mention these issues in his article on the dollar, since they represent the means through which the currency situation affects the real economy. He indeed implies that the United States should welcome any level of capital inflow that the rest of the world is willing to supply because he regards it solely as a vote of confidence in the American economy and ignores the costs thereof, despite the resulting further increase in the external deficit and debt. He has even publicly criticized his predecessors' intervention last fall to support the euro, which helped to keep the problem from getting worse.

This is precisely the mistake made by the Reagan administration, with its huge tax cuts and "benign neglect" of the exchange rate--a "strong dollar" policy without using the term. That approach, which Dr. Lindsey extols because it "allowed the government to borrow the large sums necessary to rebuild our country's defenses," converted the balanced current account position it inherited into huge deficits and took the United States from being the world's largest creditor to largest debtor country. Secretary of the Treasury Baker acknowledged publicly that the dollar overvaluation spawned the most widespread adoption of trade protection (quotas on autos, steels, machine tools and numerous other products) by any administration in the Twentieth Century despite President Reagan's obvious market and free-trade orientation. It set the dollar up for a "hard landing" that almost occurred in early 1987, despite two years of effort by Baker to get the currency back down with his Plaza Agreement, and contributed mightily to Black Monday in the stock market that October.

It would be a mistake for the Bush administration to adopt a "weak dollar" policy or to drive the dollar down, as its Republican predecessors did in 1971-73 (with President Nixon's two devaluations) and 1985-87 (with President Reagan's Plaza Agreement), because a freefall would be so costly as noted above. But it is sheer folly for the administration to seek to maintain the dollar at its currently overvalued levels, let alone to push it higher or even to let it rise in the markets due to renewed weakening of the euro and the yen. The Bush administration should thus develop a "sound dollar" policy under which it and its G7 partners would ease the currency down gradually, by perhaps 20 percent or so over a couple of years, both to reduce the risk of a "hard landing" and to counter the inevitable protectionist pressures (as well as to make a modest contribution to economic recovery).

Such a shift in policy could begin with direct intervention in the foreign exchange markets to support the euro, which is grossly undervalued but has declined steadily over the past few months. This would at least keep the dollar from getting stronger and could be used to signal a change in U.S. and G7

intentions. The United States and the G7 should also resist any further weakening of the yen, since Japan is still running large trade surpluses, especially if it fails to adopt the necessary domestic reforms (especially of its banking system) and seeks to rely on renewed increases in those surpluses to avoid another recession. Such intervention by the United States and G7 could avoid a repeat of the 1984-85 experience, when a further rise in an already overvalued dollar was "pure bubble" with no conceivable economic justification even in retrospect.

Unfortunately, substantial depreciation of the dollar is the only way (other than prolonged and deep recession, which obviously should be rejected) to cut the U.S. external deficit to sustainable levels--perhaps around $200-250 billion, or 2 to 2.5 percent of GDP, about half of where it now stands. Fortunately, we know that this remedy works; the sharp fall of the dollar in the middle 1980's virtually eliminated the deficit by the early 1990's. Fortunately too, it is also clear that direct intervention in the currency markets, including through rhetorical shifts ("jawboning") as proposed here, works when conducted systematically and skillfully; the modest but totally successful U.S. interventions against the yen in 1995 and 1998 are the latest cases in point.

Such a policy could hardly be attacked as mercantilist by the rest of the world since all analysts, including the International Monetary Fund in publication after publication, agree that the dollar is substantially overvalued in trade terms and because it is quite clear that no other major industrial country would have permitted its external debt and deficits to become so large in the first place. If the new approach turned out to be too successful, in the sense that the dollar threatened to decline too fast or too far, the G7 could simply intervene on the other side of the market to buy dollars, just as the Louvre Accord in 1987 stopped the fall of the dollar triggered by the Plaza Agreement, when it seemed to accelerate too sharply.

The Bush administration clearly needs an exit strategy from the "strong dollar" stance that it inherited from its predecessors. Hence Secretary O'Neill was correct when, in the administration's early days, he said, "We do not follow ... a policy for a strong dollar" and emphasized instead that "a strong dollar is the result of a strong economy." The obvious implication was that the slowdown in U.S. growth, both in absolute terms and relative to Europe and elsewhere, should produce a decline in the dollar. The Secretary unfortunately lost his nerve and immediately retreated to the "strong dollar" refuge, however, despite the fact that the resulting sell-off in the markets amounted to only about one percent against the euro (and nothing against the yen) and could in fact have become the start of the needed process of gradual correction.

The administration will simply have to try again, with a carefully calibrated strategy and greater resolve. An alteration in its rhetoric, perhaps by starting to espouse a "sound dollar" or offer a studious "no comment" when queried about the currency, can help push the foreign exchanges in the needed direction in light of their sensitivity to any change in the "strong dollar" mantra. Direct intervention vis-a-vis the euro and perhaps the yen, initially to stop their declines rather than to weaken the dollar, would help even more and would convey new guidance to the markets. Further reduction in interest rates would, of course, promote the correction and should be implemented if called for by domestic economic conditions.

The "strong dollar" approach provided a major boon to the United States and world economies for the past half decade. It has outlived its usefulness, however, and the new posture proposed here can provide similar benefits for the period ahead. We can only hope that Secretary O'Neill will not really feel that he has to "hire out Yankee Stadium and some rousing brass bands," as he has put it, when the administration faces the inevitable need to change dollar policy as its Republican predecessors did in the early 1970's and the middle 1980's.

C. Fred Bergsten is Director of the Institute for International Economics. He was Assistant Secretary of the Treasury for International Affairs from 1977 to 1981 and Assistant for International Economic Policy to the National Security Council from 1969 to 1971.