The Dollar's Weakness Is a StrengthPublished: June 04, 2003 in Knowledge@Wharton
manufacturers like it, but German and French exporters do not. Operators of hotels and tourist attractions across America are glad to see it happen, but tourism-dependent businesses overseas are not thrilled at all. The Bush administration appears to like it (although there is some confusion about this), but more than a few foreign governments are definitely nervous about it.
The decline of the dollar is getting everybody’s attention these days. Members of Wharton’s finance department and an economist at a U.S. financial institution say the dollar’s decline against some of the world’s major currencies will have far-reaching economic and political effects for many months to come, particularly in America and Europe. Indeed, the chain of events that the dollar’s movement has set in motion may have a lot to do with the outcome of the U.S. presidential election in 2004. These experts predict that the dollar will probably continue to fall, but any additional weakness should pose no problems for the U.S. economy unless the decline were to happen in a rapid, chaotic fashion.
Already the dollar is occupying the attention of the leaders of the world’s developed nations. Currency movements were a topic of discussion at the recent Group of Eight meeting in France, where European and Japanese officials expressed concern that a weak dollar could thwart global economic recovery. Finance ministers, economists, politicians and business executives also were eagerly anticipating a June 5 meeting of the European Central Bank (ECB), which is expected to address anemic economic growth by cutting an important interest rate. What’s more, Federal Reserve chairman Alan Greenspan has indicated that the U.S. central bank may be poised to cut rates when the Fed meets on June 24 and 25.
A weaker dollar is a double-edged sword with winners and losers. Some of the biggest beneficiaries of the dollar’s decline are U.S. companies, the U.S. stock market and U.S. economic growth. American manufacturers who sell their goods in countries whose currencies have appreciated against the dollar are happy because those goods are now cheaper to buy overseas.
Wharton finance professor Jeremy Siegel favors a weaker dollar “because it means cheaper export prices and higher real incomes for Americans. When you’re in a struggling economy with a lot of unused capacity like ours, I’ll take imports that are a little more expensive as the trade-off for getting U.S. companies more competitive in world markets.” Siegel says a weaker dollar also helps U.S. stocks – and the millions of people who invest in them – because higher sales abroad can lead to higher corporate earnings.
Stuart G. Hoffman, senior vice president and chief economist at PNC Financial Services Group in Pittsburgh, agrees that a weaker dollar can help U.S. manufacturers become more competitive in pricing, which can lead to higher sales and gains in market share. In today’s climate, companies that do a lot of business overseas benefit when revenues booked by their subsidiaries in foreign currencies are transferred back to the United States in dollars. This is especially true for U.S. firms that do business in Europe. The U.S. dollar has lost about 17% of its value against the euro since the end of 2002. The Canadian dollar, the Japanese yen and other currencies have also appreciated against the dollar, but not as much as the euro.
Other potential winners include U.S. hotels, resorts and other businesses that cater to tourists. Since vacations in Europe are now most costly, many Americans may decide to head for domestic beaches and mountains this summer instead of Paris and Rome, Hoffman says.
A weaker dollar also helps to allay concerns among economists about the possibility of deflation, a broad, persistent decline in prices. By making imports more expensive, the thinking goes, a weaker dollar can stave off deflation. “While a weaker currency over time is not in and of itself inflationary, it does mean the prices of some imports go up, so it works against deflation in your own country,” Hoffman explains. Fed chairman Greenspan has said it is important that the United States do what it can to avoid deflation, although he does not think that deflation is imminent.
Potential losers from a weaker dollar include European and Japanese exporters, whose goods are now more expensive to buy in the United States, and tourism-dependent businesses. “For any firm competing with Japan and Europe, [the dollar’s weakness] has to be very good news,” says finance professor Richard Marston.
Stagnation in Japan
Although most attention has been focused on the euro, Japanese officials have been concerned about the yen’s rise against the dollar. On May 29, Prime Minister Junichiro Koizumi said that the yen was too strong given the state of Japan’s economy, which saw GDP growth near zero for the first quarter of 2003.
“Japan is worried that if the yen goes to too high a level, it will cause big problems,” says finance professor Franklin Allen. In a telephone interview from Japan, where he was teaching a course, Allen says Japanese officials are “very worried about the export sector” and about the overall economy.
“It’s a grim situation here,” Allen notes. “I was at dinner with students last night and they were saying their incomes were starting to get cut quite dramatically. The mortgage rate in Japan is about 2% on a 40-year mortgage and property prices are reasonable. But the students were worried about taking out mortgages because five years from now they aren’t sure they will have the incomes to make the payments.”
Ultimately, Japan will do all it can to get the yen to the level it wants by buying as many dollars as necessary, according to Allen.
As far as European companies are concerned, Marston says a stronger euro means they have little choice but to cut profit margins. “This is a significant jolt for them to have such a large appreciation of the euro. For companies in direct competition with the U.S., this is definitely very bad news. Eventually, they’ll have to raise prices in the U.S. and lose market share.”
Recession in Europe?
Marston says a strong euro holds the potential to tip some countries in the euro zone into recession. “They’re at the brink [of recession] anyway,” he says. Figures released on May 15 showed modest growth of 0.8% in the euro zone in the first quarter compared with the year-earlier period. Germany’s economy actually contracted 0.2% in the first quarter. In the fourth quarter of 2002, its economy contracted 0.3%.
According to Marston, euro-zone countries do not have much room to maneuver when it comes to fiscal policy. Those countries cannot spend their way out of economic malaise because they are required by statute to keep their budget deficits below 3% of their gross domestic product. “They don’t have traditional ways to respond to slowdowns. It puts them in straightjackets,” he notes.
Hoffman is not as pessimistic about the future of Europe’s economies, but says a strong euro certainly does not help Europe, particularly economies like France’s or Germany’s that rely on exports for a large portion of their GDP growth. “I don’t know if they could fall into recession but Germany does a lot of exporting. If Germany is exporting to France, Italy or Spain, the fall in the dollar has no effect. But to the extent that Germany exports to the United States or China or Japan, [a strong euro] does make their companies less competitive. This is also true for France. Whether it would push them into recession – I wouldn’t go that far.”
Germany itself does not seem overly worried. Ernst Welteke, president of the Bundesbank, Germany’s central bank, and a member of the ECB council, has said that he is not concerned about the euro’s strength, according to a May 28 story in The Wall Street Journal. Welteke said German exports would remain competitive if the euro was worth about $1.15. On June 2, the dollar traded at $1.17 to the euro. The dollar had hit an all-time low of $1.19 against the euro the previous week. (It is interesting to note that the euro today is worth what it was when it was introduced in January 1999 – $1.17. At its weakest point against the dollar, the euro was worth about 82 cents.)
Whether or not recession is a real possibility in Germany or elsewhere in the euro zone, the topic of gloomy economic prospects was expected to be high on the agenda of the ECB at its June 5 meeting. The ECB, which sets monetary policy for the 12 nations that use the euro, was widely expected to cut its key interest rate from 2.5% to either 2.25% or 2% – a move that would be aimed at putting a charge into Europe’s struggling economies. The ECB has cut interest rates twice in recent months – by one half a percentage point in December and a quarter point in March.
A Tough Task
Marston says the ECB has a difficult job trying to set a common monetary policy for countries whose economic situations – high unemployment may be the biggest problem in one place, high inflation in another – can be so different. He notes, too, that the ECB is unlike the Federal Reserve in its basic purpose. The Fed has a dual mandate to maintain price stability and full employment, while ECB’s charter gives it just one chief task – preventing inflation. But Marston suggests the appreciation of the euro will compel the ECB to become “more proactive” in using monetary policy to grease the skids for economic growth.
In the long run, he adds, “the ECB has to establish a very strong bias against inflation. That’s what has made [former Fed chairman Paul] Volcker and Greenspan so successful. That’s ultimately the central bank’s job. On the other hand, when the world economy is becoming very, very sluggish, holding those rates at a given level at some point becomes counterproductive.”
America’s Dollar Policy
There has been some confusion in recent weeks about what U.S. policy is toward the dollar. Treasury Secretary John Snow has made comments indicating that the United States welcomed a weaker dollar. But at the G-8 meeting President Bush said “our policy is a strong dollar.”
The apparent contradiction between Snow’s comments and Bush’s has caused the currency markets to “question” U.S. policy, according to Hoffman. Yet he plays down the controversy, noting that there is no significant disagreement between Bush and Snow, that they are not trying to “artificially” raise or lower the dollar via their comments, and that currency traders should not assume there is a “secret code” they need to decipher in order to determine the government’s true dollar policy.
“The treasury secretary and even the president have said, ‘Let the markets determine where the dollar should be. Our policy is we want a strong dollar but let the markets determine it,’” says Hoffman. “Of late, the markets have been knocking the dollar down, although in an orderly … fashion. It’s not a crisis.”
Siegel agrees that too much has been made of Snow’s comments. He says statements by government officials have much less of an impact on the dollar’s movements than do market forces. “I think there’s a huge overemphasis on the administration’s position on the dollar, in particular Treasury Secretary Snow’s comments,” says Siegel. “Really, the forces on the dollar are very, very broad and have more to do with world capital flows and investment. The stance of the administration and Snow has little power to change the dollar’s basic direction. Greenspan has far more power in influencing the direction of the dollar than anyone else in the administration.”
Although the dollar’s decline against the euro has been the most dramatic in recent months, the greenback has slowly been losing ground to the euro for the last couple of years. That weakening stands in stark contrast to the 1990s when the dollar was made the king of currencies by foreign investors flocking to the United States to reap the benefits of high interest rates and a booming equity market.
“The appreciation of the dollar in the 1990s had a lot to do with the foreign appetite for American securities,” Marston explains. “During the bull market Europeans poured money into the U.S. stock market, including European companies taking over U.S. companies. It wasn’t interest rates that attracted investment as much as equities and direct investment in American companies. It took a long time for that to turn around. But what turned the dollar down was a very significant slowdown in foreign investments in the United States.”
Today, according to Siegel, “low interest rates in the U.S. are one reason we’re seeing a decline in the dollar. Short-term money is seeking the highest returns around the world. With interest rates low here, Europe looks better. You also have to consider the long-term money in the stock market. There’s a nice rally in stocks here. But I don’t think the U.S. is viewed quite as favorably as it was in the late 1990s, so long-term money is being liquidated a bit here.”
The Wharton faculty members point out that the U.S., which is saddled with a large current-account deficit, needs to attract hundreds of billions in investments from abroad each year. “If you have a current-account deficit of 5% of GDP, you have to have it matched by 5% of capital inflows,” says Marston. “That’s an enormous amount to attract every year. It was easy to do that during the soaring stock market. But when the market collapsed, Europeans really cut back on their investments in this country.”
Adds Allen: “There is an issue, going forward, about whether we can keep borrowing that 5% from overseas each year to finance the current-account deficit. That may not be sustainable. If foreigners hold 45% of U.S. bonds and 30% of U.S. equities and they decide to get out, that could be a big problem. We could have a meltdown in asset prices.”
Further Decline in Dollar Seen
Hoffman and the Wharton scholars say no one can predict how much farther the dollar will fall, but it seems that there is room for further depreciation.
The dollar will continue to decline over the next six to nine months, Hoffman predicts, but the decline may not be as concentrated against the euro as it has been. He says an “orderly” depreciation of the dollar should be no cause for alarm, but warns that a dollar crash could seriously damage the U.S. economy if the Federal Reserve felt compelled to boost interest rates to slow the dollar’s decline. Higher rates would stifle any nascent recovery.
“I don’t think there’s a magic number above which you’re okay and below which you’re in the danger zone,” Hoffman says. “But speed is relevant. If the dollar falls 10% in a month, that’s bad. That could show real lack of confidence in the economy. I don’t think that will happen.” Hoffman predicts the dollar could fall another 6% against the British pound, the Mexican peso and the Canadian dollar over the next six months. If so, “I don’t think that presents a problem for the U.S. economy in any way, shape or form.”
The 2004 election
If a weaker dollar and an interest rate cut by the Federal Reserve in late June jumpstart America’s economy, would that bode well for Bush’s reelection chances in November 2004?
“There’s no guarantee. It depends on the timing,” says Marston. “In the 1991-92 period, the economy didn’t seem to be turning around and that cost the first President Bush dearly. We’re less than a year and a half from the election. That’s not a lot of time for the economy to turn around and for people to recognize that the economy has turned around. Remember that employment lags GDP growth. Companies make long-term investments before they hire people back. It’s going to be a jobless recovery for a while. We don’t have the same kind of recessions we used to have. We used to lay off blue-collar workers and bring them back when the economy recovered. Today we fire white-collar workers and find ways to substitute for them, and we don’t have to bring back as many when recovery happens. And that’s not going to help President Bush.”