SYNOPSIS: Good Macroeconomic policy calls for a weaker dollar

Treasury Secretary Paul O'Neill recently gave an interview in which he dismissed claims that the dollar was overvalued, arguing that concerns about our trade deficit are based on "trivial and wrong notions." He also thinks that concepts like gross domestic product are obsolete. I took his remarks as an indication that the dollar's inevitable decline will probably come sooner rather than later. And while that will be embarrassing for Mr. O'Neill, it will be a good thing for our economy.

Why does Mr. O'Neill's nonchalance suggest that the strong dollar's days are numbered? Because there is a clear analogy between the soaring dollar and the recent tech bubble. As Robert Shiller pointed out in his book "Irrational Exuberance," a gradually rising asset price acts like a natural Ponzi scheme, in which each new wave of investors creates capital gains for the previous wave. If this goes on long enough, it can silence the doubters.

But eventually the process ends and you know that the end is nigh when white-haired executives reject old-fashioned accounting. That means that the mania has spread to the suits, and that the Ponzi scheme is about to run out of suckers.

The dollar has been rising against the currencies of other industrial countries since the middle of the 1990's. This sustained rise has made dollar bears look foolish, but it has also priced U.S. products out of world markets. Since 1995 the U.S. current account deficit, the difference between what we buy from foreigners and what we sell to them, has quadrupled to an astonishing $450 billion. It goes without saying that this is the biggest such deficit in world history. More startling is the fact that at 4.5 percent of G.D.P., the U.S. current account deficit is a bigger share of our economy than the deficits of Indonesia or South Korea on the eve of the 1997 Asian financial crisis.

In the past, deficits this large have always led to a currency plunge. True, one hears arguments to the effect that the rules have changed, that this time is different. Those arguments were presumably what Mr. O'Neill had in mind when he dismissed concerns about the payments deficit. Alas, it would be easier to take those arguments seriously if they weren't so similar to the arguments people used to justify the high dollar of the mid-1980's, just before it started dropping.

More ominously, I heard exactly the same arguments especially the claim that rising productivity justifies a strong currency — used to dismiss concerns about Mexico's current account deficit just before the 1995 peso crisis, and again in Asia two years later.

But would a sharp drop in the dollar be a catastrophe? Probably not. In fact, if the dollar is going to plunge one of these days, now would be a pretty good time. I wouldn't have said that a year and a half ago; but times have changed.

Not long ago a drop in the dollar would have been a clear negative for the global economy. A weaker dollar, which makes U.S. goods cheaper compared with the products of other countries, redistributes world demand toward the U.S. and away from the rest of the world. Back when the U.S. economy was booming, this would have been shipping coals to Newcastle; we already had plenty of demand, while other economies were depressed.

Now, however, the U.S. economy has stumbled, and the strong dollar is one of the reasons the Fed is having trouble pulling us back from the brink. So right now a weaker dollar is in America's interests. It still might create some problems elsewhere — but on the other hand it might be just the shock needed to wake the European Central Bank and the Bank of Japan from their policy slumbers.

Is that a call to action? Should we actively seek to drive the dollar down? There's a precedent: In 1985 James Baker, who was then secretary of the Treasury, organized an international effort to tame the too- strong dollar. It's still debatable whether his efforts made any difference; possibly the dollar would have fallen in any case. But it was a political triumph: Mr. Baker managed to take credit for the dollar's decline. Alas, Mr. O'Neill's ramblings have probably prevented him from achieving any comparable feat.

But never mind Mr. O'Neill; the great dollar decline is coming, and we should welcome its arrival.

Originally published in The New York Times, 8.1.01