The Pros and Cons of a Weak Dollar


By Steve Rosenbush The U.S. dollar is the benchmark world currency, the standard by which all others are measured. And usually, it's the others that race to keep up with the symbol of U.S. economic might. But of late, the relationship has been reversed. The greenback has been sagging and wheezing and looking a bit soft around the middle. Its value relative to the euro has declined 8.3% this year, to $1.29 per euro on Nov. 11 from $1.17 on Apr. 26. The dollar has lost 21% of its value against the euro since President Bush took office in January, 2001.

The drop reflects the concerns of international investors, who hold 43% of the U.S. national debt, according to Gail Dudack, chief investment strategist at SunGard Institutional Brokerage, in New York. Foreigners have pumped enormous amounts into the U.S. over the past few years, and "now are getting nervous that too much of their assets are in dollars," says David Wyss, chief economist at Standard & Poor's.

VICIOUS CYCLE. The inclination to begin parking their money elsewhere became apparent after the Nov. 2 reelection of George W. Bush. Since then, investors in the Mideast and Asia have gone on a euro buying binge, says Tom Rogers, a currency analyst with Informa Global Markets. They're concerned that the policies Bush has promised to enact during his second term will worsen an already record federal budget deficit. Left unchecked, investors fear a soaring deficit will lead to higher interests rates, lowering the value of U.S. stocks and bonds.

The vicious cycle works like this: As the currency deteriorates, it becomes more expensive to import goods and services from other countries, fueling inflation. In an effort to pull investors back, central banks often raise interest rates when their national currencies lose value. But as anyone who remembers the '70s knows, the combination of rising interest rates and on-the-run inflation can be a devastating economic cocktail.

For now, inflation is under control. It's rising at a 2% annual rate, excluding volatile food and energy prices. Wyss expects it to stabilize at 2.5% next year. "It's not a big increase," he says. The Federal Reserve can continue to raise short-term interest rates at a slow, orderly pace to make sure the growing economy doesn't overheat.

Longer rates will rise slowly, too. Wyss says the 10-year bond will hit 5.5% next year, and that mortgage rates will rise to 6.75%, "still pretty low by historic standards," he says.

PRICIER IMPORTS. Meantime, the weaker dollar has some benefits in the short term. It could lower the trade deficit, which is dangerously high. And it stands to boost job growth, especially in critical areas such as manufacturing. Says Dudack: "The decline in the dollar may not be as onerous as it looks."

But the dangers of a weak dollar aren't evenly distributed, especially this time around. It's mostly a concern for countries in Europe and Asia. A higher dollar makes it more difficult for U.S. consumers to afford products imported from those regions, which rely heavily on exports as engines of economic growth. A weak currency typically leads to inflation, because it prompts companies that export to the U.S. to raise prices.

"Things aren't working that way this cycle, and it's unlikely that will change," Dudack says. Japan and other counties in Asia depend on exports for economic growth. They can't afford to raise prices, because anything that damages the U.S. economy hurts them directly, she says. They're holding the line on prices, taking a hit to their profit margins instead.

RISING EXPORTS. The falling dollar also stands to help the U.S. manufacturing sector produce more domestic jobs. As U.S.-made goods and services become cheaper compared to those of rivals in other countries, demand will increase. That will boost domestic production of machine tools, cars, even the long-troubled textile industry, according to Wyss.

Japanese-based auto makers are already increasing production at their U.S. manufacturing plants, Wyss notes, because these are now the low-cost suppliers, and those cars are being shipped to Europe. Wyss expects job growth to stabilize at about 175,000 to 200,000 jobs a month. As U.S. exports rise, that should help reduce the current-account deficit, which measures the outflow of capital and trade. It's way too high, at a current level that exceeds 5% of GDP.

Europe, which is in much worse economic shape than the U.S., now finds itself in a real bind. Economic growth there will range from 1.8% to 2.8% next year, according to Ronald Simpson, an analyst with Action Economics. Growth prospects in the U.S. are about 3.5%. Federal deficits in Europe, measured as a percentage of gross domestic product, are higher than they are in the U.S.

CHINA'S CHEAP RIDE. The unemployment rate in France is 9.9%, vs. 5.5% in the U.S. As the cheap dollar puts pressure on its export industries, Europe will have to find ways to spur domestic demand for goods and services. The most obvious method would be to cut interest rates, but the European Central Bank, worried about inflation, is nervous about such a move.

Making matters worse for the Europeans, China has pegged the value of its currency to the dollar. Under it's agreement with the World Trade Organization, Beijing doesn't have to let its currency float until 2008. Until then, China also gets to enjoy the economic boost that a cheap currency can bring.

None of this is reason for the U.S. to celebrate its battered buck. In a global economy, the U.S. needs a strong European market that can afford to buy U.S. goods, such as airplanes, to keep its economy going. A weaker dollar may be in U.S. interests for the next few years, but not at the expense of its trading partners over the long haul. Rosenbush is a senior writer for BusinessWeek Online in New York


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