International Economics Update
August 2001
Copyright (C) 2001 The International Economics Network
http://www.internationaleconomics.net

Marginal Notes.

How The Mighty Hath Fallen: The Inexorable Slide of the U.S. Dollar

The U.S. dollar, which has defied gravity for an exceedingly long time, has, this month, begun to display signs of receding from its previously lofty position. Whereas the decline (to date) has been measured at best, it is reflective of certain fundamental conditions. I had argued previously ('Why the Alps Tower the Rockies', http://home.pacific.net.sg/~jamus/comment8.html) that this would be due to a shift in prevailing economic conditions, premised on the weakening of the American economy in general. This remains true to a large extent, and several developments over recent months have reinforced the case.

First, the productivity paradox/miracle has started to look more and more tired. The latest data to emerge from the U.S. Bureau of Labour Statistics (Madrick 2001) has lent support to Robert Gordon's (1999) school of thought that the productivity rise was largely cyclical and hence misleading. In a sense, this seems to have been precluded by the stock markets - the S&P 500 has slid close to its lowest levels all year, the Dow has slipped through 10,000 once again, and the NASDAQ - well, we know about the NASDAQ. As this dismal finding shakes and eventually gets digested by the markets, the last of the Internet euphoria will dissipate, allowing capital to flow to previously ignored markets elsewhere and shoring up the strengths of other currencies.

Second, the U.S. current account deficit looks to be even more precipitous. Whereas apologists for the sustainability of the $450 billion (4.5 per cent of GDP) exist (Quinlan & Chandler 2001), the truth of the matter is that such stunning trade deficits cannot be justifiably sustained indefinitely. Whether or not the no-Ponzi game condition held in the New Economy bubble, foreigners are progressively unwilling to fund the spending patterns of U.S. consumers. More ominously, the U.S. current account deficit now stands at a level not dissimilar - and in some cases exceeding - that of the economies of East Asia prior to the 1997 Asian financial crisis. Apprehension over the state of affairs has not gone unnoticed at the highest levels – witness the recent IMF criticism that “…the size and duration of the current account deficit… raise concerns that the dollar might be at risk for a sharp and sustained depreciation” (IMF 2001, p. 25).

Third, the concerted decline of the dollar against all currencies, and not just against a singular currency such as the yen, provides additional reason to believe that capital is truly flowing elsewhere. The U.S. economy is no longer the paragon of economic strength that it once was. The formal introduction of euro notes and coins in 2002 will further erode the use of the dollar as a reserve currency as the euro becomes more firmly entrenched in the international financial landscape. And if economists such as Sinn & Westermann (2001) are to be believed, the use of the euro in physical form will ease the entry of black-market European currencies (especially the Deutschemark) into general circulation, injecting fresh liquidity into the system and buttressing the use of previously locked-out capital.

The slide has hitherto, arguably, been small - the dollar changes hands at about 0.92 dollars to the euro, and some 120 yen buys a buck. Indeed, the relative size of the decline prompts one to question the forces that kept the dollar out of whack - was it a mere case of currency overshooting, a la Dornbusch (1976)? Or has it been more of a slow reversion to Purchasing Power Parity? [1] In the absence of new data and directed empirical research, the question remains open.

Still, it is not premature to venture that the recent decline is a combination of mean reversion to PPP coupled with some short-term overshooting, especially in response to the productivity 'miracle' and the dot-com boom (bubble). But regardless of the specific hypotheses that will no doubt arise in attempting to explain the strong-dollar puzzle, the points raised above can only mean that the chimera [2] of Mr. O'Neill's 'strong-dollar' policy has most definitely been hurt, if not slain, and it is likely that the future will increasingly see it finally being buried.

References

Dornbusch, R. (1976). 'Expectations and Exchange Rate Dynamics', Journal of Political Economy 84 (December): 1161-76.
Froot, K.A. & K. Rogoff (1995). 'Perspectives on PPP and Long-Run Real Exchange Rates'. In Handbook of International Economics 3, edited by G. Grossman & K. Rogoff. Amsterdam: North-Holland.
Gordon, R.J. 'Has the "New Economy" Rendered the Productivity Slowdown Obsolete?' Mimeograph. Evanston, IL: Northwestern University, 1999.
International Monetary Fund (2001). ‘United States: 2001 Article IV Consultation – Staff Report, Staff Statement, and Public Information Notice on the Executive Board Discussion’, IMF Country Report no. 01/145.
Lim, J.J. (2001). 'Why the Alps Tower the Rockies'. Mimeograph. Online: http://home.pacific.net.sg/~jamus/comment8.html.
Madrick, J. 'Revised Productivity Figures Disprove Beliefs of New Era', International Herald Tribune, Aug 31, 2001.
Quinlan, J. & M. Chandler (2001). 'The U.S. Trade Deficit: A Dangerous Obsession', Foreign Affairs (May/Jun).
Sinn, H.W. & F. Westermann (2001). 'Why Has the Euro Been Falling? An Investigation into the Determinants of the Exchange Rate', NBER Working Paper no. 8352.
Taylor, A.M. (2000). 'A Century of Purchasing Power Parity', NBER Working Paper no. 8012 (forthcoming in Review of Economics and Statistics).

Endnotes

1. It is generally acknowledged that mean reversion to PPP occurs after 3-5 years (Froot & Rogoff 1995). There has been the contention that PPP has shown greater persistence in recent times, although Taylor (2000), employing a barrage of empirical tests, has not found any evidence to that effect.
2. The strong dollar policy can be credibly described as a mirage, because despite the widespread rhetoric of the Bush administration in maintaining such a policy, actual policy moves have not justified such a belief. 'Letting the market decide' can hardly be described as anything more than a tacit endorsement of market forces, and not a strong-dollar policy per se.

Website Additions.

1. The proceedings of the American Political Science Association for year 2000 remain online till August - if they interest you, download them NOW. Some papers of interest in the field of international political economy are linked on the site: http://www.internationaleconomics.net/research-ipe.html.

2. There have been a fair few additions to research papers in international finance (http://www.internationaleconomics.net/research-finance.html) as well as currency crises (http://www.internationaleconomics.net/crisis.html).

3. The site has now incorporated a search feature, courtesy of Google. Check it out at http://www.internationaleconomics.net/search.html.

Interesting Readings.

1. Asia Rising: Asia Times argues that the economic geography of East Asia is likely to metamorphose in such a way that China and India will become the economic powerhouses for the region (nothing new here), and that Asia will experience increased levels of integration ('Beijing and Delhi the wise choice', http://www.atimes.com/se-asia/CH04Ae01.html). The China issue comes to the fore as Singapore admits its concern over the strength of China ('Singapore Unveils New Economic Plan', http://www.iht.com/articles/29956.html; 'Singapore nervously eyes emergence of Chinese dragon', http://www.atimes.com/se-asia/CH23Ae01.html), and Bloomberg's William Pesek Jr. ponders the vaccum that China might potentially create in the region in its relentless quest for growth ('This China Syndrome Won't Cause Asian Meltdown', http://quote.bloomberg.com/fgcgi.cgi?ptitle=William%20Pesek%20Jr.&touch=1&s1=pesek&tp=ad_topright_bbco&T=markets_fgcgi_content99.ht&s2=ad_right1_bbco&bt=blk&s=AO4SGpRXDVGhpcyBD). Still, Asia Times' Devin Stewart asserts that there is little need for Japan to fear China ('The threat to Japan's economy is Japan, not China', http://www.atimes.com/japan-econ/CH25Dh01.html). Philip Bowring, writing in the Tribune, asserts that there is little need to fear China ('Much Exaggeration of the Economic Challenge From China', http://www.iht.com/articles/30814.html).

2. More Euro Neuro: The changeover to the euro may well prove to be the singular, largest financial transaction in history. This, however, has not been without its share of hiccups, as the International Herald Tribune reports ('Euro Notes: Bonanza for the Underworld?', http://www.iht.com/articles/29382.html).

3. Globalisation/Globalization: Are we, or aren't we? This is the question increasingly being asked by academia ('1492 and all that', http://www.economist.com/finance/displayStory.cfm?Story_ID=748671). From the issue of free labour flows in an increasingly integrated world economy - which has raised issues of 'importing' talent versus the flip side of suffering a 'brain drain' ('Exporting Workers: Filipinos Count the Cost of an Exodus', http://www.iht.com/articles/29497.html), to the elusiveness of capital flows ('Asian capital: Hiding and fleeing', http://www.atimes.com/editor/CH18Ba01.html), it appears that the questions and attendant problems will not be resolved any time soon.

4. How The Mighty Hath Fallen: The U.S. Dollar shows some signs of retreating at last. Early reports ('Hit by Investor Fears, Dollar Drops Against Euro', http://www.iht.com/articles/29483.html).

5. Nuking Trade: The WTO has formally ruled in favour of the EU (and against the US) in a major trade dispute over the use of tax breaks as disguised subsidies to American exporters ('America’s taxing trade troubles', http://www.economist.com/agenda/displayStory.cfm?Story_ID=747956); these could have major implications for trade talks happenind in Doha in November ('Tackling Trade', http://www.economist.com/agenda/displayStory.cfm?Story_ID=718596). The barriers to trade remain heavily weighted in favour of the developed nations, especially with regard to agriculture ('Global agriculture club ice cold and mean', http://www.atimes.com/global-econ/CH25Dj01.html).

6. Argentina's Lifeline: After a long-drawn series of negotiations, the U.S. has approved an IMF-sanctioned bailout of Argentina. This controversial decision is not without its fair share of critics ('Still huff, puff and pay?', http://www.economist.com/agenda/displayStory.cfm?Story_ID=750433; 'Argentines Face Renewed Sacrifice', http://www.iht.com/articles/30330.html). IHT offers an explanation for the dramatic about-face by America ('Behind the Bush Shift on IMF', http://www.iht.com/articles/30316.html).

7. The World is Sinking: An excellent article by the newspaper named after the dismal science summarises the dismal state of the world economy ('A global game of dominoes', http://www.economist.com/finance/displayStory.cfm?Story_ID=748689). Stanley Fisher, from the IMF, concurs ('IMF's Fischer Says World Economy is Teetering on the Edge of Recession', http://quote.bloomberg.com/fgcgi.cgi?ptitle=Economies&s1=blk&tp=ad_topright_econ&T=markets_bfgcgi_content99.ht&s2=ad_right1_economies&bt=ad_position1_economies&middle=ad_frame2_economies&s=AO4rKfBWVSU1GJ3Mg).

Endnotes.

This update is sent by request to subscribers. If you wish to join the mailing list, please click on:

http://www.internationaleconomics.net/contact.html

And enter your email address on the form there.

You will receive a verification message confirming your subscription to the International Economics Update mailing list. Please feel free to forward this mailing on to colleagues and friends who might be interested in the subject matter. The usual disclaimers apply.

This mail is not spam. You have received this mailing only because you are on the International Economics Update mailing list, for which it is believed that you have voluntarily subscribed to. If you believe that this message was sent in error, or if you wish to remove yourself from the mailing list, please send an e-mail to:

webmaster@internationaleconomics.net

and you will be removed promptly. Alternatively, you may click on the link below.