There's something about international trade and finance that makes people lose all sense of proportion. Only a few weeks ago, the American press proclaimed that globalization had slain the dragon of inflation. Pundits castigated the Federal Reserve for raising interest rates to slow the American recovery. Now that our nation is open to world trade, they said, economic expansion cannot drive up prices.
Then the dollar began sliding on world markets—and suddenly the press was filled with extreme statements of the opposite kind: Bill Clinton is another Jimmy Carter, 1994 is 1978, and a plunging dollar will bring soaring inflation and/or abort the recovery.
Let’s calm down and look at this dollar drama with a little more perspective. Reports of the death of inflation were greatly exaggerated. Similarly, the dollar’s recent slide is unlikely to trigger serious inflation or provoke a recession, or to last long enough to do so. That is, unless the Federal Reserve loses its nerve. The main—though not the only—thing we have to fear is fear itself.
Why isn’t the dollar’s slide to date cause for concern? For one thing, the dollar has not fallen all that far. Over the past year, it has declined only about 10 percent against the yen, and less than 7 percent against the mark. For another, the dollar has not been weak on all fronts; while it slumped against Japan and Germany, other important trading partners like Canada and Mexico have actually devalued against the dollar. All told, in the last year the dollar has fallen no more than 3 percent on average against the currencies of America’s trading partners.
Compare these currency movements with those between 1985 and 1987. Then, the dollar fell from 258 yen to 129 yen and from 3.3 marks to 1.6 marks, and its average exchange rate fell more than 30 percent. The great dollar slump of those years was a good 10 times as big as this one—yet even that spectacular slide was not enough to derail the economic recovery then in progress.
And, after all, why should a declining dollar create economic problems? There is only one reason: A falling dollar can feed inflation, and lead the Federal Reserve to raise interest rates. But this solitary reason is also a slim one; even large changes in the dollar’s value will affect inflation only modestly. Despite the rhetoric of globalization, trade just isn’t that important to the American economy. We spend only 11 percent of our income on imports, which means a 10 percent decline in the dollar will raise domestic prices by about 1 percent.
To justify grave worries about the dollar, foreign exchange markets must go into a free fall that drives the dollar much, much lower than its current level—say, to 75 yen or to 1.3 marks. Is this likely?
The answer is no. One can never rule out manias and panics in financial markets, of course, but the international markets contain many level-headed investors who are prepared to ride out a short-run storm for a long-run sure thing.
And a dollar that weak would be a sure thing. After all, in the long run exchange rates strongly affect nations’ ability to sell goods and services to other countries. If the financial markets make the dollar so inexpensive that the United States has a huge cost advantage in just about everything, then sooner or later market realities will force the dollar back up again.
Indeed, most people who do cost and price comparisons think the United States is in a very strong position even at current rates. A much weaker dollar would almost surely bring in investors willing to bet on eventual capital gains when the currency recovers. In turn, the inflow of capital from these investors would prevent the dollar from falling further.
So, is there anything to be worried about? Yes. For while the markets will not abort the recovery, the policy makers might.
The clear and present danger is that the Federal Reserve will overreact to the declining dollar, raising interest rates to stabilize our currency at the expense of the domestic economy. Most indications are that the Fed knows better—that America’s central bankers, unlike their counterparts in many other countries, understand that the exchange rate is only a statistic, not a symbol of national honor and virility. But that view, sensible though it is, may be hard to maintain if the dollar should take another sharp plunge.
Originally published, 6.26.94