There is good reason why the dollar is strong. In 1992, the U.S. attracted about 18% of global capital flow, according to the International Monetary Fund. That share rose steadily throughout the decade, reaching 64% in 2000. Global capital poured into American companies and equities because of the higher growth potential of the U.S. economy. And that potential was greater than Europe's or Asia's because of a rising federal budget surplus as well as a higher productivity growth rate thanks to new information technologies. It also helped to have two Treasury Secretaries who publicly supported a strong dollar without qualification.
Foreign exchange traders are seeing qualification everywhere and are starting to slap at the dollar. Both President Bush and Treasury Secretary Paul H. O'Neill recently undermined the dollar by saying that only the currency markets determine the value of the dollar. They should have known that the markets would interpret their comments to mean the Bush Administration might not support the dollar if it came under pressure. And perhaps they did.
The currency markets are also nervous about the Bush Administration's commitment to a federal budget surplus. That surplus is being unexpectedly whittled away as the income tax cut and the economic slowdown lower federal tax receipts. Instead of paying down $57 billion in debt, the Treasury will now borrow $51 billion for the third quarter. A recovery later this year or next could send surpluses back up. But the bond market, with surprisingly high long-term interest rates, is signaling its doubt that the Bush Administration is really committed to future budget surpluses.
Foreign exchange traders are also fretting about productivity. U.S. companies are cutting back on capital investment as their earnings crater. Thanks to enormous spending on information technologies in the '90s, this can continue for a few quarters without hurting productivity. But if the profit recession drags on into 2002, cutbacks in investment could erode productivity growth and return on capital. That could slow inflows of overseas capital and hurt the dollar.
It may well be that dollar is somewhat overvalued. It's up 6.3% this year alone and currencies invariably overshoot in the market. But managing a smooth 10% decline is a near-impossible task likely to cause a chaotic 30% crash. Washington would be wise to stand by the dollar and not undermine it with fiscal irresponsibility or ambiguous commitment.