The Value of the Dollar Must Fall
As of late last week, the dollar was trading for about 140 Japanese yen. This was at least 20 yen too high, and anyone buying dollar-denominated assets at that price was making a big mistake.
The basic point is very simple: There is no sensible long-term forecast for the dollar that can justify its current value. That means that everyone who is willing to buy or hold dollars is either failing to take a long view or betting that he can get out before the dollar comes down too far. At some point, the bubble on which the dollar is floating will come into obvious conflict with reality, and everyone will try to get out at once--and the result will be a dollar crash.
To understand this argument, it is important to realize that anyone who decides to put his money into one or another currency is implicitly making a forecast about the future exchange rate. For example, suppose that the one-year interest rate in Japan is 5%, while in the United States it is 8%. Then anyone who has the choice of putting money into either country, and who chooses to put it in the United States, is in effect betting that the dollar will not decline by more than 3 percentage points over the next year. (Similarly, putting money in Japan is in effect a bet that the dollar will decline more than 3 percentage points).
What forecasts are the markets implicitly making now? Never mind the short-term forecasts: Nobody knows what may happen over the course of three months, or even a year. But over a decade, economic constraints begin to apply. It becomes necessary that the forecast made by the market imply feasible paths for the balance of payments, foreign debt and so on. So let’s look at fairly long-term bonds--specifically, government bonds due in mid-1998. Looking at the financial page, we discover that in Japan such bonds yield about 5%, while in the United States they yield about 8%. That is, the market is implicitly forecasting that over the next nine years the dollar will decline against the yen no more than roughly 8% minus 5%, or 3% per year.
Is this possible? No, for at least three reasons.
The United States has higher inflation than does Japan, so it has to have a steadily falling dollar just to keep the real exchange rate constant. The United States would need a substantially lower dollar even now just to stabilize its growing foreign debt, and the steady erosion of what is left of U.S. technological superiority requires a dollar that declines over time to compensate.
On the inflation issue, the underlying inflation rate in the United States is about 5%, while in Japan it is more like 1%. This alone means that if the dollar were to decline as slowly as the market apparently expects, the United States would become steadily less competitive on costs and prices as time went by.
Meanwhile, almost all estimates suggest that the dollar needs to fall substantially if the United States is not to have an explosive growth of foreign debt. Major international agencies such as the International Monetary Fund and the Organization for Economic Cooperation and Development were forecasting widening U.S. deficits after next year even before the recent run-up in the value of the dollar.
A recent study by William Cline at the Institute of International Economics, using middle-of-the-road numbers, estimated that simply to slow the rate of growth of U.S. foreign debt to a sustainable rate--not to stop its growth, which would be much harder--the yen would have to rise 28% from its late-1987 level in real terms, implying a dollar-yen rate in current prices of not much more than 100. The longer that decline is delayed, the more the dollar must drop, because of the growing burden of foreign debt. So the prospect is that sooner or later the dollar must fall very sharply in real terms. Yet the financial markets seem to believe that it actually can rise.
Finally, when looking at the dollar-yen rate it is impossible to avoid the broader issues of competitiveness. Who can look at recent experiences without being amazed and somewhat depressed by the ability of Japanese firms to hold onto their market share and by the timidity and conservatism of U.S. firms despite an unprecedentedly weak dollar? In 1980, we thought that U.S. firms could be competitive with an exchange rate that, at 1989 prices, would have been about 190 yen. In 1989, the Japanese obviously felt quite comfortable at 130 yen. What do you think the competitive rate will be in 1998?
Not everyone agrees with this diagnosis, of course. Let me mention two excuses commonly made for the strength of the dollar and explain why they won’t wash.
The first excuse is that of purchasing power parity. Look how cheap everything is in America compared to Japan, say the advocates of this view; surely this must mean that the dollar is undervalued against the yen and must rise.
The problem is that in order to pay its way in the world, a country must pay its way on world markets, not impress visiting business people with what a bargain it is. That is, the sign of an undervalued dollar would be a convincing demonstration that firms considered the United States a highly attractive place to produce for world markets, not just to visit. And the plain fact is that this is not happening on a large scale. The export boom of 1987-88 has slowed, and if there is a rush to export new products from the United States, it is happening very quietly.
The other excuse offered for the strong dollar is that its position as a key currency somehow means that the usual rules do not apply to the United States. The cheap answer is that the dollar’s special role may not last long: The yen and especially the European Currency Unit (ECU) are rapidly coming to play comparable roles. But in any case, the point is nonsense. If a Saudi businessman prefers to have a London bank account whose value is indexed to the dollar rather than the pound, this does not add to U.S. purchasing power in any significant way--and yet that is all that the special role of the dollar really amounts to.
There are other excuses--blame it all on the Recruit Co. scandal, or the power of the Greens, or Tiananmen Square. All of them fail under scrutiny. The simple fact is that the current level of the dollar is the result of a market that has lost its anchor in reality, in which nobody takes a view more than a few months ahead.
None of this says that the dollar must crash tomorrow, or even this year. But crash it must, sooner or later. My own image of the exchange market is that of one of those cartoon characters who steps off the edge of a cliff and manages to walk on air for five or six steps before noticing that there is no ground underneath; it’s only when he realizes that he is suspended in mid-air that he plummets. It’s the same with the exchange rate: One of these days the market will notice that there is nothing real supporting the dollar, and down it will fall.
