Are Doomsayers Crying Wolf Over the Weak Dollar?

Congratulations, of sorts, to the U.S. dollar, which this month marks the 10th anniversary of its bear market.

Perhaps in commemoration, currency traders grabbed the buck and shook it again on Thursday, sending it down to 1.489 German marks in New York, within a breath of its 1994 low of 1.486 German marks. The dollar also plunged to 97.45 Japanese yen, not much above the post-World War II low of 96.05 yen set last year.

Ten years of a mostly declining currency might seem to be nothing to celebrate, especially with Mexico’s latest financial crisis as a backdrop. As the Mexican peso has lost 40% of its value since mid-December, that country’s stock and bond markets have plummeted, in the process spurring a slow meltdown of markets across Latin America.

But the dollar’s long devaluation, which began in February, 1985, and has continued in on-again, off-again fashion ever since, has transpired with relatively little of the pain that some economists had predicted 10 years ago.

Indeed, the same warnings heard Thursday as the dollar tumbled anew have been making headlines for a decade: A falling dollar whose root problems are a huge federal budget deficit and an equally massive trade deficit will 1) discourage foreign investment in U.S. securities; 2) boost inflation, and thus interest rates, by raising prices on imported goods; 3) depress Americans’ relative standard of living, and 4) lower global confidence in the American economy.

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Theoretically, all true. But in practice, investors who have been avoiding U.S. stocks and bonds for 10 years because of dollar concerns have badly miscalculated. “The idea that a weak dollar would have an appreciably negative effect on U.S. financial markets has been a losing bet for a long time,” notes James Grant, publisher of Grant’s Interest Rate Observer newsletter in New York.

Consider: The stock market, as measured by the Dow industrials, is at a record high of 3,987, more than three times its level in early 1985, while long-term bond yields remain lower today than in 1985 despite last year’s rate rise.

As for inflation, the “core” consumer price index--excluding food and energy costs--rose at a 2.6% rate last year, the lowest in 29 years.

The dollar doomsayers have been wrong for a number of reasons, analysts point out. For one, the benefits of a weak dollar--in particular, the pricing advantage it provides U.S. exporters--may have been underestimated 10 years ago. Helped by the dollar, U.S. industry’s global competitiveness has resurged, which has translated into soaring sales and earnings for many U.S. firms.

At the same time, the instinct to survive has driven Japanese and German exporters, among others, to find ways to slash costs rather than force ever-higher prices on the all-important American consumer. Thus, inflation has been contained.

As for foreign investment in U.S. securities, the dollar’s ongoing decline may indeed have discouraged some foreigners from dabbling in U.S. markets, for fear that what they buy today will be worth less tomorrow if the dollar keeps falling.

But Americans owned most of their own securities 10 years ago, and they still do today. Foreign participation in U.S. markets has never been huge as a percentage of the total dollar amount of securities, which means the well-being of U.S. markets doesn’t depend on foreigners. They own only 5.6% of U.S. stocks, for example. Mexico can only dream about saying the same someday.

Does it really not matter, then, if the dollar begins a fresh slide at the hands of currency traders with nothing better to do? How low is too low for the beleaguered buck?

Those questions may be debated a lot in coming months, because new pressures are building on the dollar: The threat of a slowing U.S. economy, fallout from the U.S.-engineered Mexican bailout plan (what’s good for the peso would be considered bad for the dollar, since Uncle Sam is paying) and the possibility of higher interest rates in Europe, which could draw more money to European bonds, helping buttress the Continent’s currencies.

If history is any guide, however, any negative effects on stocks and bonds from further dollar weakness will be short-lived, and not worth lost sleep for most U.S. investors.

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Foreigners’ U.S. Stake

Foreign investors don’t own a significantly larger share of U.S. stocks and bonds now than they did in 1982--which is a big reason why a falling dollar hasn’t been deadly for U.S. financial markets. Percentage owned by foreigners:

1982

1994*

* Third-quarter data

Sources: Federal Reserve Board, Goldman Sachs & Co.