Making Sense Out of the Dollar’s Fall

Last week, the Reagan Administration’s chief economic policy maker, Treasury Secretary James A. Baker III, said the government would do nothing to prevent the dollar from falling. This week, President Reagan said he wants the dollar to stabilize.

What exactly is going on? Confusion over the dollar is rampant, reflecting sharp differences over policy inside the Administration and the difficulty of trying to avoid an economic downturn in the wake of last month’s stock market crash.

At bottom, the United States is currently in no position either to push the dollar down or to hold it up. The result is that the dollar will move for now primarily in response to marketplace speculation.

So what? For most Americans, unless they take a foreign vacation, the level of the dollar in international currency markets seems far removed from their daily lives. But the uncomfortable reality is that the dollar’s value is a central factor in determining the U.S. standard of living.

The U.S. currency was exceptionally strong during the first half of the 1980s because foreigners, for a variety of reasons, were eager to hold the dollars Americans paid for foreign goods. That allowed the United States to live far beyond its means--to buy much more from abroad than it was required to ship overseas. But the strong dollar priced U.S. manufacturers out of world markets and fueled a dramatic increase in the nation’s trade deficit.

Now everything is changing. Foreign investors are increasingly reluctant to accumulate rising amounts of dollars. The dollar has fallen from its Himalayan peak of early 1985.

Gradually or suddenly, that means the U.S. trade deficit will have to shrink, Americans will have to consume less, and standards of living will be squeezed.

The causes and effects are complicated and interrelated. Here, in question-and-answer form, is why every American will feel the effects of the dollar’s fall.

Q: Does the United States benefit when the dollar falls?

A: Yes, in one major way: A cheaper dollar helps reduce the U.S. trade deficit. That is because Americans have to pay more dollars to buy imports, while foreigners can buy U.S. goods more cheaply.

Q: Why was the dollar relatively stable against other major currencies for most of the year?

A: For most of this year, the United States cooperated with other major industrial nations to help stabilize the dollar at roughly the levels agreed upon last February at a meeting in Paris. The Federal Reserve, as part of the bargain, defended the dollar by gradually pushing up U.S. interest rates to encourage reluctant foreign and domestic investors to keep their holdings in dollar securities. The Fed and other central banks were also helping by buying dollars in world currency markets.

Q: If a falling dollar helps the trade balance, why would the United States want to stabilize the dollar?

A: Because a falling dollar is inflationary. By February, the dollar had already been falling for two years, and that meant U.S. consumers had to pay more and more dollars for foreign goods. In particular, Paul A. Volcker, who was then chairman of the Federal Reserve, worried about the effect of a falling dollar on inflation.

More than that, the Reagan Administration thought it could narrow the trade deficit even if the dollar remained stable. It was counting on European countries and Japan to stimulate their economies so that their citizens could buy more U.S. goods. If the dollar fell too much against those countries’ currencies, exporters in Europe and Japan might lose so much business in the United States that their own countries would plunge into a recession and cut back even further on their purchases from the United States.

Q: So what started the dollar’s recent fall?

A: It began with another disappointing monthly report on trade. When the government reported on Oct. 14 that the trade deficit for August was higher than expected, the dollar fell. That’s because the traders who move an average of $200 billion a day around the world in search of the best return were convinced that the Fed would be under pressure to let the dollar fall to help reduce the trade deficit. Not wanting to hold depreciating dollars, the traders sold them in massive amounts.

Q: But isn’t the federal budget deficit, not the dollar, to blame for the continuing trade deficit?

A: Not really. Practically every country has a budget deficit and if budget deficits led automatically to trade deficits, every nation would run a trade deficit, which is impossible.

More to blame, strangely, is the dollar’s role as a global currency. For a long time, foreigners who earned dollars by selling goods and services to the United States were only too happy to keep their dollars and invest them in the United States instead of converting them into their own currencies.

That allowed the United States to simultaneously finance large government borrowing, private investment to increase, and a consumer spending boom to begin. We did not have the resources to produce all of what we needed at once, and so we bought much of what we needed from overseas.

Thus the budget deficit and the trade deficit were two effects of the same cause--foreigners’ willingness to hold increasing amounts of dollars.

Q: Then why did the dollar start coming down in early 1985?

A: Supply and demand. Ultimately, so many dollars were in foreign hands that they began losing some of their value.

Q: If the dollar needs to fall to help narrow the trade deficit, what’s so bad about that? Did anything else happen during last month’s market crisis to make matters worse?

A: Yes. Investors in the bond market also pushed interest rates up sharply because they knew the Fed was trapped. If the dollar fell, that would fuel inflation, and interest rates would eventually go up as well to protect lenders from inflation’s impact on their earnings. But if the Fed tried to fight a lower dollar, it would have to do so by boosting interest rates. Knowing that interest rates would head higher either way, investors tried to stay ahead of the trend by quickly bidding rates up.

Q: What’s wrong with higher interest rates?

A: High interest rates threaten to weaken the economy by making borrowing more expensive. Business won’t invest as much in new equipment, individuals will buy fewer houses and cars, and the economy may eventually plunge into recession.

Q: Why did the stock market react so violently?

A: Higher interest rates tend to depress business profits. More important, they attract investments to bonds and other securities that pay fixed interest rates from stocks, on which the return is variable--that is why the Dow Jones industrial average fell more than 90 points on the day the trade report came out and dropped further during the rest of the week.

Q: What was happening in the rest of the world?

A: Adding to the Fed’s dilemma were higher interest rates in West Germany and indications that Japan might also boost rates. If interest rates moved higher overseas, the Fed would be forced to squeeze the money supply here even harder to make rates high enough to encourage investors to keep their holdings in dollars.

Q: How did the Reagan Administration react?

A: Treasury Secretary Baker, beginning the day after the trade figures came out, blamed the Germans for higher interest rates and suggested that the U.S. government might teach them a lesson by stopping its effort to support the dollar. A falling dollar would punish German exporters.

Q: Did Baker’s tactics work?

A: They backfired. The stock market panicked, in part out of fear that international economic cooperation was breaking down. Germany retreated by lowering interest rates--but only after the U.S. stock market plunged 508 points on Black Monday, Oct. 19.

Q: Can the pieces be picked up now?

A: It won’t be easy. The Fed, faced with the danger of a financial collapse after the stock market crashed, immediately announced it would flood money markets with cash. Interest rates dropped, in part because of the larger supply of funds from the Fed and in part because many panicked investors rushed to put their money in safe interest-bearing securities.

Once interest rates began falling rapidly in the United States, many investors shifted their funds out of dollars and into other currencies where the returns looked more attractive. The Reagan Administration, abandoning any serious effort to defend the dollar, also wants lower interest rates because it fears a recession during an election year.

Q: So that means the dollar will continue to fall?

A: Probably, but not necessarily. The best way out of the current predicament is faster economic growth abroad. That way, U.S. firms can find more buyers abroad, and manufacturers in Europe and Japan can make more money by selling at home than in the U.S. market. That would ease pressures on the dollar to fall.

The United States needs to help by reducing its budget deficit. In this way, it can use more of its own savings to finance business expansion instead of government borrowing. That, too, would ease pressure on the dollar.

Q: What about the trade deficit?

A: Whether the dollar falls farther or not, the trade deficit has to come down. As foreigners decide they do not want to accumulate more dollars, they will quit selling more to us than we buy from them.

Q: Isn’t that good for America?

A: It’s good for workers but not so good for consumers. True, it means foreigners will no longer be employed in huge numbers to make the goods that Americans are buying. But it also means that Americans must stop consuming more than they can produce. And that’s another way of saying U.S. standards of living will slip.