What a Cheaper Dollar May Bring

They say Christopher Columbus must have been the world’s first economist because: 1) he clearly didn’t know where he was going (although he thought he did); 2) when he arrived, he didn’t know where he was (although he thought he did); 3) when he got back, he didn’t know where he’d been (although he was sure he did), and 4) he did it all on borrowed money.

That is certainly the way I have felt this past year as the world’s economies and financial systems lurched from one crisis to another, all the while just kind of whistling loudly past the graveyard.

That there are menacing financial imbalances afoot was confirmed by the recent decision of the world’s major central bankers and finance ministers to talk down the U.S. dollar. In 10 days, the dollar lost 8% of its value against a basket of currencies weighted by trade volume. That’s a heavy hit for such a short period. The dollar actually had been slowly falling since last February, but in seven months’ time its value had dropped by only 6% to 7% and, in September, the dollar was threatening a renewed rise. However, even with the action of the past few weeks, the U.S. dollar remains at least 15% above its range during the period from 1973 to 1981. It is not yet what one would call a bargain.

Three questions emerge from that startling exercise: Was it a good idea? Will it work? What happens now?

Japanese, German Problems

If you were a typical economist, the answer to the first question would be no. But, if you were a Japanese or German central banker faced with the problems of a weak domestic economy, high unemployment, increasingly restive politicians, higher-than-needed interest rates and a lower-than-needed exchange rate, what would you do? You couldn’t lower interest rates to spur your economy because that would drive your currency even lower, which is the last thing you wanted. If you sincerely wanted to stimulate your own economy, you would have to get the U.S. dollar out of your way first. Besides, protectionist sentiment in the United States was growing so strong that it threatened to scuttle 50 years of hard work to promote world trade and global growth. With that in mind, I guess it was probably about as good as any idea available at the time.

Will it work? Well, in typical economese, yes and no. If the world’s central bankers caught the dollar at or close to a fundamental turning point from which it would have gone down anyway, the intervention strategy probably will work. It will work because all it will have done is to speed up the inevitable. And there is some merit in doing it quickly and massively. Among other things, flushing out much of the exchange-rate risk in one fell swoop through intervention may make it possible to let U.S. interest rates come down or at least hold steady and still keep the capital flowing in to finance the huge gap between our nation’s capital needs and our internally generated saving. Lower interest rates would promote renewed economic growth here and elsewhere, and I am certain that is the desired objective at this time.

But, when the talking and fiddling with exchange markets are done, those deficits will remain and must be financed. Thus, one must hope that the effect of a declining dollar on our exports and imports--our external deficit--will be more rapid than normal, thus reducing our need for foreign capital. Of course, one hopes also that something dramatic can be done to reduce the budget deficit--our internal deficit--but I see no reason to be hopeful on that point.

In the end, we may be asking too much of intervention, and the dollar may rebound again. Nevertheless, it is probably reasonable to conclude that the dollar was ripe for a fall anyway and, besides, the central bankers seem determined. So, I don’t think I’d bet against them just now.

If the Dollar Stays Down

Let’s assume that the dollar stays down for the duration. What will happen? Regardless of what anyone says, no one knows. We have no experience with the aftereffects of a dollar so strong for so long at a time of glaring deficits both inside and at the borders of the country. Nor do we have any idea what happens when the dollar falls sharply after such a period. Add to that the present state of the world’s financial structure, and we clearly are in uncharted waters. What follows, then, are just a few of the possibilities that flow from depreciation of the dollar’s value.

Any shift in U.S. demand away from imports and toward domestically produced goods--plus any growth in exports that might be brought about by a falling dollar--will tend to accelerate domestic economic growth. Further, it will convince domestic producers eventually that their inventories are too low. Chances, therefore, are that the economy in early 1986 will surprise us by its strength, especially in those industries directly affected by import competition.

One would expect, too, that to bring about this shift in demand, the prices of imported goods would rise. That in turn would provide opportunities for domestic producers to raise prices after several years of being squeezed. But isn’t that inflation? It will look like inflation and feel like inflation, but, if monetary policy does not validate it through higher money growth (a very big if), it can’t last long enough to work its way into the system. All prices need not rise, but there is no denying that prices are likely to rise in those areas where import competition has been severe.

We may be surprised, however. Domestic producers have been squeezing their costs and payrolls so that their break-even points--the sales volume at which they begin to make money--are dramatically lower than a few years ago. But it never did them any good because the dollar kept on rising, wiping away the fruits of their efforts. Thus, just a small shift in consumer demand away from imports and toward domestic goods could generate prodigious productivity gains, lowering unit costs and making it possible to boost profits dramatically without a sharp increase in prices. Recent data on productivity trends in U.S. manufacturing strongly support that notion.

Besides, it is said that profit margins of foreign producers and U.S. importers of foreign goods have swollen in recent years because all the benefits of the rising dollar were not passed along to consumers in the form of lower prices. If so, then those producers and importers will have plenty of latitude to keep prices from rising steeply even though the cost of the imported goods is rising as the dollar falls. Since they fought hard for the market shares they now have, they won’t give them up easily. But let’s not kid ourselves. We’ll get some inflation.

There are many other possible benefits that could flow from devaluation, among them the prospect of sharply higher corporate profits in the U.S. in 1986, a better outlook for agriculture, a diminution of protectionist sentiment and a much improved growth outlook for the rest of the world.

But the real message to be drawn from these actions is that the politicians of the industrial nations have made a fundamental decision that will affect us for years to come. What the central bankers really told us was that the sackcloth-and-ashes era in global economic management is over. After several years of increasingly harsh and restrictive fiscal or monetary policies, weak economies and rising unemployment, political tolerance limits finally have been reached.

In the late 1970s and early 1980s, the global body politic decided rightly that it was necessary to pursue anti-inflationary policies and risk the politics of low growth and high unemployment.

However, the risks of continued disinflationary policies are now so visible and ominous, especially in the world’s financial systems, and the outlook for employment is so dismal, that we have begun sending signals to our leaders that we don’t want to play the disinflation game anymore. Besides, the evidence seems to support the notion that inflation is no longer the key problem. Employment and financial viability are the problems.

Have we really buried inflationary expectations so deep that we can afford to take those chances? Given the record of political economics over the centuries, the long-term answer probably is no. At the same time, like Christopher Columbus, in our long sail toward a new disinflationary world, how are we to know whether we’ve found it if we never stop to test where we are? We may be surprised, as we were in the early 1960s, by how far we can push pro-growth policies without igniting inflation. In any case, we’re about to give it a go, and we’ve decided to take our chances with inflation.