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The dollar's value makes the US economy vulnerable to international forces

By Robert Hormats - posted Saturday, 1 September 2001


Let me try to make a few broad points and then try to go through a little bit of an analysis as to why I think the dollar has defied the law of gravity in some cases.

First, the strong dollar policy today is taking place in a very different context from the strong dollar policy of the Rubin and Summers years. Then, we had a policy of a strong dollar and we also had a strong economy. Now, we have a strong dollar policy, which is really a legacy of the last administration, which this administration has taken up, but we have a much weaker economy.

The only problem is that, as our economy has weakened, so have a lot of other economies. And while there are problems posed by a strong dollar there are a whole host of other problems. In many cases, those other problems are much more severe and, in many cases, localised in the sense that they’re not dependent on currency markets or currency misalignments. They took place, those problems emerged, from domestic economic problems, domestic economic weakness.

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Now, to some degree, certainly in the manufacturing sector in the United States, the strong dollar has exacerbated those problems. However, because of the investment boom and then the investment bust, because of an American economy which was overheated becoming a much slower economy, growing at a slower rate, the blame for those cannot be primarily laid at the foot of the dollar. So while the dollar poses problems, we need to look at it in the context of a whole series of other issues and, to a degree, it is making some of those other issues for some sectors considerably worse.

Second point is that there are two sort of competing issues that the United States government has to deal with. One, the United States has today a very large imbalance between domestic savings and domestic investment. And that money comes from the rest of the world. The United States has to attract net $425 billion, give or take, this year to fill the domestic savings-investment imbalance. And one of the things that has concerned the Treasury and concerned the Fed is to make sure that we have an attractive environment for that money to come in. If the environment becomes less attractive - for a whole host of reasons, any one of which could make it less attractive - then we run the risk of foreigners investing less money into this economy, and you have higher interest rates, you have a weakening dollar, and you have consequences for the inflationary outlook, and consequences for the growth outlook.

And this, I think, is a significant issue which the Treasury and the Fed have to deal with. The Fed in particular - Alan Greenspan had the opportunity in his Humphrey-Hawkins testimony on Tuesday to comment on the dollar. And he did not. And one of the reasons he did not is because he is concerned anything that could begin to push the dollar down could make his job considerably more difficult than it already is and it is already, as we know, quite difficult.

The other side of the coin, however, is that exports, as a portion of GDP, account for a larger portion of GDP than housing and autos combined. So weakening in the export sector is a very severe problem for the overall economy. And there, the strong dollar is unquestionably one of the elements that has led to a weakening of exports.

There are other elements, too, and that, of course, is that Japan’s been in a recession; that the East Asian economies, because of their dependence on the US, among other things, have begun to weaken. That’s not a dollar issue so much as a very weak growth outlook in some of our major economies that bought goods, particularly capital goods. And the area where exports have declined most dramatically is in the area of capital goods exports, and we can see that. The numbers are quite vivid and there are a lot of American jobs, as Steve has pointed out, tied up in that sector.

So you’ve got the financial issues and the inflation issues on one hand and very real sectoral issues on the other, and trade accounts for a large proportion of GDP, about 12 per cent – as I say, about the same as autos and housing combined.

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Now, when you look at where the dollar is overvalued, it’s not uniformly overvalued. I think where the overvaluation is most obvious is in the case of the euro. This is not to say it’s not overvalued against others, but there, I think, is where the BIS probably would argue that the levitation - the act of levitation was greatest.

So there are a couple of issues that are important in trying to understand that.

First of all, it was hoped, indeed expected by most Europeans, that Europe would outperform the US this year. In fact, it has outperformed the US in terms of growth, but by a much smaller margin than was anticipated. A much better performance by Europe than the United States would have been positive for the euro and probably strengthened the euro somewhat. That substantial outperformance has not occurred.

Second, if you look at the interest rates, you would assume when the Fed cuts rates, the dollar would go down. That is one of the transmission devices for lower interest rates. It tends to lower the dollar and the European Central Bank really has not been as aggressive in lowering rates. Normal economics would tell you something is a little wrong here.

The difference is markets don’t just look at interest rates at the moment. They look at where those are leading. And the assumption of the market is that the aggressive Fed lowering was going to lead to growth in the United States in coming quarters, whereas the slowness of the ECB in lowering - in other words, keeping rates somewhat higher - will mean a slower economic outlook.

So the market looked through the initial decision by the Fed and by the ECB to what they thought was going to occur as the result of those decisions. They foresaw stronger growth in the US and weaker growth in Europe because of the central banks and the credibility of Alan Greenspan. So the American central bank surely has to be one major reason, one among many, that the dollar has performed this act of levitation that sort of surprised the BIS. So psychology plays a role in the market.

Third, long-term interest rates, and here is something that’s very important, I think. People say: well, the American stock market’s been very volatile. The US is having negative wealth effect after the positive wealth effect. The problem is foreigners do not buy a lot of American equities. They buy bonds, and if you look at the bond rates between, say, the United States and Germany, the real long-term bond yields are not very different. The United States also has a stronger, more liquid market in dollar assets, corporate assets, agency paper, which are the things foreigners buy. Therefore, that’s a very attractive way of holding money, particularly if you’re confident, as most people are, about the long-term inflation environment.

The last point about money flowing in is that a lot of money has come in via foreigners buying American assets through direct investment or acquisitions using money, not stock, but using money. That has been a very robust number. It’s declining a little bit, but it’s still quite strong.

So if you put all those together, and you look at some of the structural issues, which is the European Parliament a few days ago voting against this commission proposal for uniform rules on takeovers within Europe - they were supposed to liberalize the takeover market. It was voted down.

It’s useful to look at the current economic weakness today and that of 1990, when we actually had a recession. The role of the foreign sector in periods of economic weakness in this country has been largely positive in the sense that, in 1990 for instance, real domestic demand in Japan and Germany were growing at about 5 per cent in each of those countries. Today, Japan’s probably in a recession, its fourth in the past 10 years, and German growth, give or take 1 per cent, something like that. If they’re lucky, they’ll get to one percent, but certainly declining. So you haven’t really gotten strong robust growth.

The other is that, in the period 1990, the dollar had been depreciating in value for five years. Now, as people have pointed out quite correctly, the dollar has been appreciating in value for the last several years.

So on the whole, in 1990, foreign demand, exports in general, exports to the rest of the world, contributed 1.4 per cent, positive 1.4 per cent, to American growth. And that helped to cushion the recession of 1990.

Now, we’re seeing a very weak export environment for the United States - Japan, Western Europe, elsewhere - and many of these countries have been relying on the US to get out of their weakness. Well, the laws of economics say every country can’t export its way out of slow growth. And yet to hear the rhetoric, you would think that’s what they were trying to do.

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This is an edited version of fourth of five speeches given to the Economic Strategy Institute – Derivatives Study Center forum: "Is the value of the dollar harming the global economy?" at the National Press Club on Thursday, July 26, 2001. Click here for the full transcript.



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About the Author

Robert Hormats is Vice-Chairman of Goldman Sachs (Int'l).

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