The Mysteriously Strong Dollar.

Why the greenback keeps defying predictions of its imminent fall.

It has been more than six years since the dollar embarked on the rising trend. Since its low point in April 1995, the dollar has risen 68 percent against the D-mark, 55 percent against the yen, and 45 percent in trade-weighted terms, reaching its highest level in sixteen years. For most of this period, rising dollar trend coincided with the U.S. economic boom. Hence, most analysts were attributing the dollar upswing to cyclical reasons as reflected in favorable growth and interest rate differentials. This has not been a satisfactory explanation, however.

In the four years preceding the beginning of the dollar's rise, the U.S. economy was also expanding (though less vigorously) while Europe was growing more slowly and Japan was largely stagnant. But the dollar was falling sharply during that period. Furthermore, the U.S. economic boom ended a year ago. Consequently, both growth and interest rate differentials moved against the dollar, the U.S. equity markets slumped, corporate profits plunged, and the trade deficit reached a record high. Yet the dollar has remained strong and kept rising against all major currencies, contrary to conventional wisdom and most economic predictions.

The dollar/euro relationship is a special case in the strong-dollar puzzle. The euro was launched two and a half years ago amid great hopes and expectations that it would soon become a global currency that would challenge the dollar. Many economists had predicted that it would appreciate strongly from its initial parity rate of $1.17 due to massive portfolio and monetary reserve shifts from the dollar area.

This has never happened. On the contrary, the euro fell sharply to 82 cents in October 2000 and has settled down in the 86-90 cent range, a one-quarter depreciation since its inception. Importantly, the euro kept falling even after the U.S. economy moved into a pronounced slowdown bordering on a recession, thus contradicting the popular view that it would appreciate because Euroland would be insulated from that slowdown.

What were the reasons for that disappointing euro behavior? Some economists, most notably Robert Mundell, the intellectual godfather of the euro, contend that the reason was excess liquidity resulting from the pooling of monetary reserves of the member countries. Others blame the lack, or a very slow progress, of structural reforms the new currency was supposed to trigger. Still others point to the fact that the euro is still a virtual currency and that the forthcoming introduction of euro notes and coins is causing a flight of illicit money into dollars.

All these factors may have contributed to the euro's decline. But the main reason was the performance of the European Central Bank (ECB). It has failed to establish its credibility as a truly independent bank, as provided for by the Maastricht Treaty. Its top officials have been talking with different and sometimes contradictory voices; at various times one could detect political interference in its policy decisions. Above all, whether by neglect or design, the ECB has kept the euro undervalued. This helped improve Euroland's export competitiveness but defeated the original raison d'etre of the euro as conceived by Charles de Gaulle over forty years ago--to compete with the dollar as a global investment and reserve currency.

The euro's weakness and its reasons only partially explain the strength of the dollar, which has risen against all currencies. What are the main reasons for the continuing dollar strength despite the apparent turn in the American business cycle? And why did most economists fail to predict this strength? There are two main reasons: first, a lack of recognition that the dollar is a unique currency because of its global characteristics and the impact of the American economy on the rest of the world, and second, the failure to pay enough attention to the U.S. government's foreign exchange policy and the related psychology of currency markets.

The best illustration of the first of these two factors is the U.S. balance of payments. The coincidence of the strong dollar and rising external deficits is the most puzzling aspect of the dollar saga. From 1995 to 2000, when the dollar appreciated over 40 percent, the U.S. current-account deficit nearly quadrupled. Moreover, last year the deficit reached the highest level ever, both in absolute and relative terms (4.5 percent of GDP), and there are no prospects for an improvement this year. In fact, 2001 will be the twenty-sixth consecutive year of trade deficits and the twentieth year of current-account deficits. (The United States had a small current-account surplus in 1991, but it was an extraordinary event related to payments of several foreign countries as their contributions to finance the Gulf War.) Any other country that would have such large and rising external deficits for such a long period would have seen its currency dropping, but the dollar rose. The reasons lie on the financing side of the balance of payments (the capital account).

A country can run a balance-of-payments deficit only to the extent that it can finance it, either through borrowing or depleting its foreign exchange reserves. In the case of the United States, there are no problems whatsoever in this respect. In fact, the United States is in a highly advantageous position because it doesn't need to borrow in a conventional sense. The financing comes voluntarily because of the international function of the dollar as the prime trade, investment, and reserve currency; the attractiveness of the United States as an investment outlet; and the size, scope, and openness of U.S. capital markets. Moreover, the United States is in the unique position of being able to finance its external deficit in its own currency, in contrast with most other countries that must scramble to get the necessary foreign exchange.

This is illustrated in Table 1. Although the current deficit rose last year to a record level, it was easily financed by net inflow of private capital. That left only a small deficit in the overall balance of payments, which was actually reduced by nearly 29 percent from the previous year. This final deficit was financed by the increase of monetary reserves of foreign central banks in the United States, the result of the dollar's role as the pre-eminent reserve currency. So despite the statistical deterioration of the current account, the overall balance of payments improved. It is particularly noteworthy that 65 percent of the current-account deficit was financed last year by foreign direct investment. All this clearly demonstrates that it is capital flows rather than trade flows that determine the dollar exchange rate.

TABLE 1

U.S. Balance of Payments
(in billions of dollars)

                                          1999      2000     % Change

  I. Current Account

     Exports of goods                     684.5     772.2    +12.8
     Imports of goods                   -1029.9   -1224.4    +18.9
     Merchandise Trade Balance           -345.4    -452.2    +30.9

     Income from services                 272.8     293.5     +7.6
     Payments for services               -189.2    -217.0    +14.7
     Services Balance                      83.6      76.5     -8.5

     Income from U.S. assets abroad       285.3     352.9    +23.7
     Payments on foreign assets
       in the U.S.                       -298.9    -367.7    +23.0

     Investment Income/
       Payments Balance                   -13.6     -14.8     +8.8

     Unilateral Transfers                 -48.9     -54.1    +10.6

     Current-Account Balance             -324.3    -444.6    +37.3

 II. Capital (Financial) Account
       (private)

     Foreign direct investment            301.0     287.6     -4.5
     Foreign portfolio investment         323.5     432.8    +33.8
     Bank borrowing                        54.2      87.9    +62.2
     Other                                 90.7     178.1     N.M.
     Statistical discrepancy              -48.8       0.7     N.M.
     Capital inflow                       720.6     987.1    +37.0

     U.S. direct investment abroad       -155.4    -152.4     -1.9
     U.S. portfolio investment abroad    -131.2    -124.9     -4.8
     Bank lending                         -76.3    -138.5    +81.5
     Other                                -85.7    -164.0     N.M.

     Capital outflow                     -448.6    -579.8    +29.2

     Capital-Account Balance              272.0     407.3    +49.7

III. Balance of Payments                  -52.3     -37.3    -28.7

N.M. = Not meaningful

U.S. Balance of Payments
(in billions of dollars)

                                          1999      2000

 IV. Official Reserve Transactions

     Decline (+)/Increase (-) in U.S.
       official reserve assets              8.7      -0.3
     Increase in foreign official
       assets in the U.S.                  43.6      37.6

SOURCE: U.S. Department of Commerce; own calculations and
regroupings.
TABLE 2
Percent Change in Manufacturing Output
Per Hour, 1999

(Percent)

United States       6.6
Canada              2.4
Japan               3.8
Belgium             0.1
France              4.0
Germany (unified)   1.2
Italy               1.7
Netherlands         2.2
Norway              0.0
Sweden              3.0
United Kingdom      4.5

SOURCE: U.S. Department of Labor International Comparisons of
Manufacturing Productivity, April 5, 2001

Another aspect of the dollar's continued strength is the overwhelming pull of the American economy on the rest of the world. As can be seen from the balance-of-payments table, the sharp rise in the trade deficit last year was mainly attributable to strong growth in imports that exceeded export expansion. Thus, as was the case in most of the 1990's, the widening trade deficit was essentially caused by disparity in economic growth between the United States and its main trading partners, with the United States showing superior performance. It was thus a cyclical phenomenon reflecting relative strength of the American economy.

But not all the deficit is cyclical in nature. The U.S. balance of payments contains a structural component that is not likely to be eliminated even under recessionary conditions. During the twenty-five years of uninterrupted trade deficits, the United States experienced three recessions. Although the deficits responded to the ebbs and flows of the business cycle, they have never been eliminated.

There are two main causes of the structural part of the external deficits. First, the U.S. market is largely open to foreign products despite occasional bouts of protectionism, while trade barriers still exist in many U.S. trading partners, most notably Japan and China. Second, U.S. income elasticity of imports is much higher than foreign income elasticity for U.S exports. In fact, U.S. income elasticity of imports, which traditionally amounted to about 1.6-1.7 percent for each one percent growth in real GDP, has risen sharply' in recent years due to outsourcing, broadening industrial cooperation, and the expansion of foreign investments, both in the United States and abroad; it is now closer to about 3 percent.

These characteristics of U.S. international trade, whether cyclical or structural, combined with the United States being the largest importer in the world, have made America the "buyer of last resort" a powerful force contributing to economic growth worldwide. This has also contributed to the strong dollar, however paradoxically it may sound. The reason is that once the U.S. economy weakens and its import absorption diminishes, U.S. trading partners have a natural tendency to devalue their currencies to make up for their reduced exports. In short, they simply cannot afford to keep their currencies at previous levels; it is only the United States that can afford a strong dollar. This goes a long way in rationalizing the continuing dollar strength under weaker economic conditions.

The second reason for faulty predictions of the dollar exchange rate is the underestimation of the importance of psychological and policy-related factors. These factors don't lend themselves to econometric modeling, but experience shows that they play a significant role in the dollar behavior.

Looking back at the thirty-year period of the dollar's free-floating after President Nixon had shut down the gold window in 1971, one can easily distinguish two periods of a pervasive dollar weakness: the late 1970's and between the mid-1980's and mid-1990's. It is no accident that these were periods when U.S. policymakers displayed strong devaluationist tendencies, mostly by "talking the dollar down" in a mistaken belief that a cheaper dollar would eliminate or at least reduce .U.S. trade deficits. These were policies of the "B-quartet" four treasury secretaries with names beginning with the letter "B": Michael Blumenthal under President Carter, James Baker during the second Reagan administration, Nicholas Brady under the first President Bush, and Lloyd Bentsen during the first half of Clinton's administration. In fact, devaluationist tendencies in America have a long history. I am reminded of a hit song that was popular in the 1930's:

   "Let the pound go up, let the franc go up
   Let the mark go up as well
   Uncle Sam will be in heaven
   When the dollar goes to hell."(1)

The devaluationist foreign exchange policy has been rooted in the mercantilist tradition of viewing exports as good, imports as bad, and deficits as terrible. It has always had its proponents in the academic community, it has been largely bipartisan with both Democratic and Republican administrations pursing this policy, and its main constituencies have been big business and organized labor.

Big multinational corporations have been interested in a weaker dollar because it makes their exports more competitive and creates barriers to imports. But their main interest has been derived from profit translations, as it raises profits from their operations abroad when translated into dollars. Big labor has always considered the dollar depreciation as protection against imports and as contributing to job creation in the United States. Devaluationist foreign exchange policy is indeed a protectionist measure; it constitutes protectionism on a macroeconomic scale.

To be sure, devaluationist foreign exchange policy has not been the sole cause of the dollar's weakness. During the past thirty years, there were recessions, energy crises, the savings & loan debacle, high inflation, stagflation, and a stock market crash. All contributed to the dollar weakness. But depressed market sentiment, attributable to the perception that the U.S. government is interested in debasing its own currency, has always played a decisive role.

It took U.S. policymakers a while to understand all the implications of the weak-dollar policy. In particular, to understand that because of the main characteristics of U.S. foreign trade--high-income elasticity of imports and low price elasticities of both imports and exports--a dollar depreciation brings only limited and temporary benefits to trade. The best evidence is that, despite the lower dollar, trade deficits didn't shrink; on the contrary, they expanded. Moreover, these benefits are far outweighed by negative consequences: higher inflation, higher interest rates, a deterioration in the terms of trade and, above all, disincentives to innovation and productivity growth.

To the credit of President Clinton and his last two treasury secretaries, Robert Rubin and Lawrence Summers, they understood the advantages of the strong dollar. Hence, their mantra: The strong dollar is in the United States' best interest. It appears that this policy continues under George W. Bush, which is a significant factor of the dollar strength, notwithstanding the profound deterioration of U.S. economic conditions.

A positive market sentiment related to official foreign exchange policy is a necessary but not sufficient condition of the dollar's strength. It is the fundamentals that best explain the dollar's remarkable rising trend. The main reason for the dollar's continuing strength is the fact that the United States is the most attractive place to invest. This attractiveness results from U.S. technological superiority, stronger productivity growth, growing population, a deregulated economy, flexible labor markets, political stability, and relatively low taxation. These factors provide foreign investors with a higher return on capital than obtainable elsewhere. Moreover, the attractiveness of the U.S. as an investment outlet is enhanced by the safety and legal protection of these investments, as well as by the depth, liquidity, and openness of U.S. capital markets.

Among the factors most attractive to foreign investors: productivity, demographics, and labor markets. U.S. productivity growth in manufacturing in 1999 (the last year available), at 6.6 percent, was by far the highest among the major industrial countries (Table 2), and for the whole decade of the 1990's it was the second highest (Table 3).

TABLE 3
Output Per Hour
Manufacturing, 14 Countries or Areas, 1979-99
Average Annual Rates of Change (1)

Country
Or Area             1979-1999   1979-85   1985-90   1990-99

United States          3.3        3.5       2.4       3.8

Canada                 2.1        3.3       0.7       2.1
Japan                  3.6        3.5       4.3       3.2
Korea                  NA         NA        NA        NA
Taiwan                 NA         NA        NA        NA
Belgium                3.8        6.0       2.2       3.2
Denmark                NA         2.1       0.5       NA
France                 3.4        3.0       3.4       3.6

Germany (unified)      NA         NA        NA        NA
Italy                  3.0        4.6       2.3       2.2
Netherlands            3.1        4.4       2.1       2.9
Norway                 1.4        2.4       1.4       0.8
Sweden                 3.4        3.1       1.9       4.5
United Kingdom         3.2        4.1       4.1       2.2

Country
Or Area             1996   1997   1998   1999

United States        2.8   3.6     4.6   6.6

Canada              -1.3   3.0    -0.3   2.4
Japan                4.6   4.2     0.2   3.8
Korea                NA     NA     NA     NA
Taiwan               NA     NA     NA     NA
Belgium              3.4    8.3    1.6   0.1
Denmark              NA     NA     NA     NA
France               0.5    6.6    1.1   4.0

Germany (unified)    2.1    4.9    0.0   1.2
Italy                0.2    1.9   -0.4   1.7
Netherlands          1.7    1.8    2.2   2.2
Norway               0.1    0.9    0.9   0.0
Sweden               2.1    6.8    2.8   3.0
United Kingdom      -1.9    0.7   -0.1   4.5

SOURCE: U.S. Department of Labor

International Comparisons of Manufacturing Productivity, April 5, 2001

(1) Preliminary for 2000 for Japan, France, Germany (unified), Italy,
and Sweden and for 1999 onward for the United Kingdom.

Strong productivity growth is not only a cause but also an effect of the strong dollar. This is best illustrated by the gap in productivity growth between the United States and its biggest trading partner, Canada, whose economy is closely linked with the United States. Productivity growth in the United States was almost three times higher than in Canada in 1999 and almost twice as high throughout the 1990's. An important reason for this striking discrepancy, frequently emphasized by Canadian economists, has been the depreciation of the Canadian dollar vis-a-vis the U.S. dollar. This was a big disincentive for innovations, technological progress, and productivity growth since it was much easier for Canadian businesses to succeed in the short-term by using the crutches of devaluation.

Some economists question the sustainability of the productivity growth explosion in the Untied States in recent years. They point to the sudden drop in productivity in the first quarter of this year. But the foreign exchange markets took the unexpected news in stride, and rightly so. It appears that this was a somewhat exaggerated reflection of the sharp weakening of the economy--a cyclical factor that doesn't change the underlying trend. Year-on-year, productivity growth in the first quarter was still a relatively strong 2.7 percent.

The fact that the foreign exchange markets didn't react to the drop in first-quarter productivity has broader implications. It indicates that the market not only views the drop as a temporary phenomenon but, more importantly, it believes that the Federal Reserve is determined to prevent a recession and that the economy should start a recovery soon.

Demographic factors also make the United States attractive. According to the recent census, the U.S. population grew 13.2 percent between 1990 and 2000, in contrast to stagnating or shrinking populations in most other industrial countries. Moreover, although the U.S. population is aging, it is aging less rapidly than elsewhere in the industrial world. The census showed that 72.7 percent of the U.S. population was below the age of 50, while the number of people in the 35-54 age range--the highest spending segment--increased by 32 percent in the past decade. Strong population growth, both natural and from immigration, and strong productivity growth have raised the potential for non-inflationary growth of the U.S. economy to the 3.54 percent range from 2-2.5 percent.

Particularly striking are contrasts in the labor markets between the United States and other major industrial countries (Table 4). The United States has by far the lowest unemployment. But the attractiveness of the United States as a place for investment goes beyond the employment conditions. From the foreign investor's point of view, the most significant factor is labor market flexibility. High labor mobility, incentives to work rather than draw unemployment compensation, and a limited influence of labor unions (14 percent of the total U.S. labor force and just 9 percent of the private sector work force), contrast sharply with low labor mobility, high unemployment and welfare benefits, and a high degree of unionization in Europe.

TABLE 4
Unemployment Rates
Approximating U.S. Concepts, in Nine Countries, Quarterly Data
Seasonally Adjusted

                      ANNUAL
                      AVERAGE              1999

Country             1999   2000    I      II    III     IV

United States        4.2    4.0    4.3    4.3    4.2    4.1
Canada               6.8    5.8    7.1    7.1    6.8    6.2
Australia            7.2    6.6    7.5    7.4    7.1    7.0
Japan(1)             4.7    4.8    4.7    4.8    4.8    4.7
France(1)           11.2    9.7   11.4   11.3   11.2   10.8
Germany(1)           8.7    8.3    8.8    8.8    8.8    8.7
Italy(1)(2)         11.5   10.7   11.8   11.7   11.5   11.2
Sweden(1)            7.1    5.9    7.1    7.0    7.1    7.1
United Kingdom(1)    6.1    --     6.2    6.1    5.9    5.9

                               2000

Country              I      II    III     IV

United States        4.1    4.0    4.0    4.0
Canada               6.0    5.8    5.8    5.7
Australia            6.8    6.7    6.3    6.5
Japan(1)            4.87    4.7    4.7    4.8
France(1)           10.2    9.7    9.6    9.2
Germany(1)           8.4    8.3    8.2    8.1
Italy(1)(2)         11.3   10.8   10.6   10.1
Sweden(1)            6.7    6.0    5.6    5.2
United Kingdom(1)    5.8    5.5    5.4    --

SOURCE: U.S. Department of Labor, Monthly Labor Review, March 2001

(1) Preliminary for 2000 for Japan, France, Germany (unified), Italy,
and Sweden and for 1999 for the United Kingdom.

(2) Quarterly rates are for the first month of the quarter.

NOTE: Quarterly figures for France and Germany are calculated by
applying annual adjustment factors to current published data, and
therefore should be viewed as less precise indicators of unemployment
under U.S. concepts than the annual figures. See "Notes on the data"
for information on breaks in series. For further qualifications and
historical data, see Comparative Civilian Labor Force Statistics, Ten
Countries, 1959-2000 (Bureau of Labor Statistics, Mar, 16, 2001),

Dash indicates data not available.

Granted, the European type of capitalism is more humane than the American type. But it is much less efficient and less attractive from the investment standpoint. While the European Union has been trying to reform its labor markets by making them more flexible, the effects are rather limited. On the contrary, there are signs of some regress in this area. For example, in France, there are proposals to penalize profitable companies that lay off their workers, which would in effect lead to regulating their profit margins. And in Germany, there are growing instances of people refusing to take up available jobs in preference for drawing generous unemployment benefits.

The welfare state has long traditions in Western Europe. Just after the end of World War II, Western Europe was consumed by overwhelming fear that the Red Army would march across the continent and swallow the West. Hence, the policy priority of all governments, regardless of their political orientations, was to make the working class happy so that it doesn't dream about the Soviet "paradise." And they were successful indeed. This was the origin of the welfare state, with its strictly regulated labor markets, extensive social programs, generous unemployment benefits, and high taxation--all of which discourage job creation, work efforts, and efficiency. Needless to say, dismantling the welfare state is politically very difficult, especially now, as economic conditions have weakened and unemployment may start rising again.

For all of the above stated reasons, the outlook for the dollar is one of continued strength in the foreseeable future. There is one factor, however, that could undermine this outlook. If the recovery is sluggish and unemployment continues rising, the Bush administration may find itself under political pressure to intervene to depreciate the dollar. Its resolve to keep the strong-dollar policy under such circumstances is still an open question. But it appears that the odds for buckling under this pressure have diminished. Early in the administration there were some doubts about the attitude of new Treasury Secretary Paul O'Neill, a corporate man who might have been amenable to devaluationist tendencies. But he seems now to be fully converted to the strong-dollar policy. And Bush's chief economic adviser, Lawrence Lindsey, has clearly articulated support for this policy in a recently published article (The International Economy, March/April 2001). Moreover, many corporate leaders are now much less interested than before in seeking a dollar devaluation. If the U.S. government resists intervention, the dollar will remain a fundamentally strong currency.

(1) From reminiscences of Robert S. Schultz, one of the founders and former president of the Downtown Economists Club of New York, as recorded in the Club's fifty-year history booklet (March 1998).

Mieczyslaw Karczmar is the New York-based economic adviser to Deutsche Bank.