What's green, goes up and down, has three digits, makes people scream
and shout, and goes by the name George?
The answer, of course, is the dollar, whose value has induced some frenetic
hand-wringing among businesses, financial markets and policymakers.
Through March of this year, the value of the dollar compared with other
major currencies had stayed doggedly buoyant despite the recent recession
and sluggish recovery. Some U.S. businesses were frantic. The strong dollar
is killing exports, many screamed, flooding the United States with cheap
goods and leading to record trade deficits.
In the summer, the dollar began to fall. Good news, yes? Hardly. Call
it frantic times two. Advocates of a strong dollar said it meant cheap
capital for U.S. businesses and was the engine of growth. A weak dollar
will pull the rug out from any economic recovery.
Then the dollar rebounded against the yen, regaining about half its earlier
loss by mid-October despite the possibility of a double-dip recession
in the United States. Enough already.
People disagree—sometimes wildly—over whether a so-called strong
dollar is preferable to a weak dollar, or vice versa. The dollar's levity,
subsequent fall and modest rebound were all met with the contrarian opinions
of being both wonderful and fatal. Both viewpoints are right, to a point;
they might be better described as half-truths.
The issue ultimately delves deep into the vagaries of exchange rate systems—the
age-old trading of one currency for another. Most of the world's currency,
including the dollar, is governed today by a floating exchange rate, where
markets dictate value. Under such a system, at least in theory, there
is nothing good or bad about a weak or strong dollar, it is simply the
price at which supply is equal to demand.
"The concepts of a 'strong' or 'weak' currency are meaningless,"
according to Steve Hanke, a currency expert and professor of applied economics
at Johns Hopkins University, a Forbes columnist and a senior fellow at
the Cato Institute, a libertarian think-tank in Washington, D.C. He was
out of the country at the time of an interview request, but responded
via e-mail. "What is important is a stable currency. Stability might
not be everything, but without stability everything [else] is nothing."
The dollar is, by virtually any standard, the world's currency.
According to U.S. Senate testimony Hanke gave earlier this year, 90 percent
of internationally traded commodities are invoiced and priced in dollars.
The dollar is also on one side of 90 percent of all foreign exchange transactions
in the world. At the end of 2001, central banks held dollar reserves of
some $1.5 trillion, or about 75 percent of central bank reserves worldwide;
60 percent of the capitalized value of all traded companies in the world
are denominated in dollars; and better than half of all dollars in circulation
are held outside U.S. borders.
Some of that dominance is the offspring of the prosperity rocket that
was the U.S. economy in the 1990s. During this period, the capital needs
of U.S. companies grew—they needed money to buy new computers, build
new plants, invest in emerging markets—while there was a coincidental
plunge in the U.S. personal savings rate. So in order for U.S. companies
to grow, financing had to come from elsewhere.
Seeing the high rates of return on investments for U.S. assets in the
1990s—especially compared with other countries—foreign investors
were more than happy to fill the void, and the U.S. economy became a capital
vacuum. By 2001, net foreign purchases of U.S. securities (corporate and
other bonds, corporate stocks and Treasury securities) hit $400 billion,
or roughly two-thirds of net savings in foreign countries, according to
a September 2002 report on global finance by the International Monetary
Starting around 1995, when the dollar was relatively weak, growing worldwide
demand for dollars fueled its steady, if jagged, climb against other currencies
over the next half-dozen years. But during this time, strong-dollar critics
were cordoned off to the fringe because the U.S. economy was doing fabulously,
thank you, so let's not mess with success.
Although the dollar dropped briefly in March 2001, when the economy officially
entered a recession, it has maintained comparatively high value in the
face of less-than-stellar conditions over much of the last two years.
In March 2002, the dollar peaked at a shade over 133 yen, its highest
rate in over a year. Meanwhile, the euro was trading for just 87 cents
on the dollar, not far off the record low of 83 cents and well below the
"even trade" threshold that most European officials had hoped
(indeed, expected) when the euro was launched in 1999.
In the face of widespread manufacturing layoffs nationwide, those who
believed that a strong dollar was bad for the U.S. economy started gaining
traction and converts. These critics began making their case with the
U.S. government to do something. There was a lot of talk, but no action.
Nonetheless, only four short months later in July, the euro reached dollar-parity
and has stayed within a few cents of that mark through October. The dollar
swooned almost 13 percent to about 116 yen. Now, strong-dollar proponents
were the ones pleading for government intervention to bolster the mighty
greenback. But while people argued about the pros and cons of this exchange
movement, by October the market gave back better than half of the dollar's
loss against the yen.
(Indeed, no two countries think alike regarding the preferred strength
or weakness of their currency, and governments sometimes engage in foreign
exchange, or forex operations—called interventions—meant to
alter a currency's value. These operations are often fruitless, for reasons
that shall go unexplored here, but the curious reader will find more on
this subject in a June 2001 Region article, "Sterilized
Feel the pain
The dollar's long-term strength and short-term volatility provide a useful
framing for the argumentative din over whether a (perceived) strong or
weak dollar is good for U.S. business.
Talk to almost any manufacturer, and a strong dollar is tantamount to
some flesh-hungry disease, because it eats them alive, making their products
more expensive (and thus, less competitive) overseas. A strong dollar
also makes imported goods cheaper (and more competitive) in U.S. markets.
Manufacturing makes up 85 percent of U.S. "goods" exports and
two-thirds of all exports, according to the National Association of Manufacturers.
In May 2002 testimony to a Senate committee, NAM president Jerry Jasinowski
said exports had fallen by 20 percent, or $140 billion, over the previous
18 months, shedding a half-million jobs in the process. The American Forest
& Paper Association blamed the strong dollar on the fact that the
trade deficit in this industry alone rose from $3 billion in 1995 to $13
billion by 2000.
The National Cotton Council said the dollar's strength has implicitly
allowed Asian exporters to cut prices by an average of 23 percent since
1997 and pushed up exports to the United States by an "astonishing"
65 percent. At the same time, U.S. profits in this industry "have
virtually disappeared"; U.S. textile shipments have declined by 25
percent, or $12 billion; and "a swath of misery has spread across
the Southeast," where much of the industry is concentrated. To understate,
the dollar's drop this past summer was welcome news to many.
But at the same time, others were bemoaning a weakening dollar. Arthur
Laffer, founder and chairman of Laffer Associates, an economic research
consulting firm in San Diego, said the strong dollar stems from a pro-growth
attitude in the United States, and is the product of complementary policies
in key areas such as taxes, trade and monetary policy. These pro-growth
policies, in turn, create a good investment environment with high rates
of return, which generates strong demand (and thus, exchange value) for
the dollar among foreign investors looking for a piece of the action.
In contrast, Laffer said, slow-growth, protectionist national policies
mean a bad investment environment and poor returns on investment, which
pushes capital elsewhere and leads to a weak currency.
"The bottom line is ... a strong dollar reflects a strong economy,"
Laffer said. "Which would you rather invest in?"
The recent IMF report answers Laffer's rhetorical question. It noted that
capital flight to the United States "has been driven by international
investors' perception that U.S. financial assets offer superior investment
opportunities." It added that investors believed productivity was
higher in the United States, that it will continue, and "that the
U.S. macroeconomic policy framework has been more conducive to high output
growth than the frameworks in place elsewhere." Simply put, the United
States looked like a good investment, and it was, outperforming all comers,
particularly over longer investment periods.
And so the answer to the question of whether a strong or weak dollar is
better for the economy appears to be, well, yes; that is, it's a
two-sided answer, with winners and losers on both sides.
1 + 1 (does not always) = 2
Such fickleness ultimately begs a broader question about different exchange
rate systems, like floating vs. fixed: whether one might be better than
another, or whether one might take some of the wildness out of the roller
The irony is that the world shifted to a floating exchange rate system
three decades ago with the expectation that exchange rates would become
less—not more—volatile. In a floating system, the dollar's value
is determined by the demand placed on it in forex markets—or more
specifically, by forex traders buying and selling various currencies to
meet the financing needs of global companies and the investment desires
of global investors. [Other types of exchange rates include fixed and
pegged; see sidebar.]
With the market now in control of exchange rates, advocates believed,
the value of a particular currency would be based more predictably on
a nation's economic "fundamentals"—things like the balance
of trade, productivity, fiscal management and the direction of leading
indicators like employment and output. This argument—that economic
"fundamentals" determine the exchange rate of the dollar—is
trotted out regularly by Wall Street wags when justifying a comparatively
high valuation of the dollar.
When the world was taken off the gold standard in the early 1970s (which
was a fixed exchange rate system) and put on a floating exchange system,
advocates believed that information on fundamentals would establish a
clear economic rationale for valuing currencies against one another. Volatility
would be prevalent at first, floating advocates conceded, but over time
currency rates would be driven by fundamentals. Exchange rate fluctuations
would thus become predictable, thereby eliminating the biggest economic
cost—namely, risk—to a market-based mechanism for valuing different
But there are a lot of cracks in that argument. For one, the fundamentals
theory has become the critics' whip when the dollar's value gets seemingly
out of whack—like this year when the dollar was strong despite a
lackluster U.S. economy, where fundamentals would suggest that the dollar
was overvalued. NAM's Jasinowski testified that "global financial
markets are not serving their natural function of rationalizing exchange
rates based on 'fundamental' factors like the strength and stability of
various nations' economies."
The reason for such a misalignment is that, simply, the theory doesn't
hold water, according to an alternate view.
In essence, currency markets are different from markets for other commodities.
To suggest that currency rates should be left to markets to establish
an efficient equilibrium is to misapply market theory on an object—fiat
currency—that is unlike any other. (Fiat currencies are mediums of
exchange that are intrinsically useless, unbacked and costless to produce.)
"For fiat currencies, there are no inherent fundamentals that determine
equilibrium exchange rates," according to economist Neil Wallace,
writing in the Minneapolis Fed's Fall 1979 Quarterly Review ("Why Markets in Foreign Exchange Are Different From Other Markets").
Most economists, given to extolling the virtues of markets in determining
economic equilibria, reflexively extend those same virtues to currency
markets, but a different logic applies to fiat currencies, Wallace warned.
Demands for fiat currencies are determined entirely by speculation. "[O]ne
goes badly astray by reasoning about the international monetary system
from an analogy between fiat currencies and other objects like apples,
oranges, and shares in General Motors," according to Wallace.
The evidence certainly seems to agree. There's no traceable pattern between
economic fundamentals and the dollar's value, particularly in the short
term. Research by Richard A. Meese and Kenneth Rogoff in 1983 demonstrated
that a fundamentals model was less useful for predicting the dollar's
future value than a naive model-which means simply that the best forecast
of future exchange rates is the current rate. ("Empirical Exchange
Rate Models of the Seventies: Do They Fit Out of Sample?" Journal
of International Economics, February 1983.)
Others disagree. Fundamentals do determine exchange rates, but only in
the big picture, according to Laffer. "Unfortunately, the world is
not so clear" regarding the direct effect that different fundamental
indicators have on the dollar's value, he said.
In general, fundamentals do affect currency strength, according to Edwin
Truman, a senior fellow at the Institute for International Economics,
a former assistant secretary for international affairs for the U. S. Treasury
and former director for international finance for the Federal Reserve's
Board of Governors. Currency values in the short term "can have wide
fluctuations for largely inexplicable reasons," Truman acknowledged.
But "it's over time" that fundamentals like an economy's productivity
and competitiveness, balanced fiscal policy and "sober monetary policy"
get reflected in currency valuations.
In other words, economic fundamentals and the dollar's exchange rate tend
to align only when the time frames are broad, the economic indicators
considered are general, and alignment means being in the same ballpark,
not sitting in each other's lap.
But skeptics point out that given such a big target, how can anything
miss? Even advocates of the fundamentals approach concede that it can't
be easily applied to near-term valuations, because the morass of details
and caveats that underlie both economic fundamentals and forex markets
create too much noise to predict currency fluctuations in the short term.
For example, one must weigh the risk mentality of investors. After Sept.
11, the dollar dropped only a few percentage points against other major
currencies. But it recovered, and then some, when investors looked to
the U.S. dollar for safe haven in an unstable economic and political environment
worldwide. In 2001—a year spent mostly in recession and compounded
by terrorist attacks—foreign investors increased their net dollar
holdings by $24 billion to $276 billion, according to the Department of
Nor does everyone involved in foreign exchange transactions have the same
objective. As an article in The Economist pointed out, forex traders have
a much different objective from government policymakers when it comes
to exchange rates and currency valuations. "Their job is to make
money, or at least not to lose it. Whatever their view of the economic
fundamentals, they cannot ignore market trends." In exchange transactions,
the dollar is never over- or under-valued. It's always worth exactly what
buyers are willing to pay for it.
Change for a dollar?
Once again, the theory that floating exchange rate systems are more
efficient might seem intuitive, but the model hasn't performed to people's
expectations, and the floating system has some nasty side effects. As
discussed earlier, a floating regime implies that the value of the dollar
will be based on economic fundamentals, but that has not been the experience.
Since the early 1970s, exchange rates have been volatile and unpredictable.
The problem with a floating exchange rate stems not from the up-and-down
volatility of how markets set exchange values, per se, but from the
uncertainty of volatility. Unpredictable volatility equals risk, the
Achilles' heel of any exchange regime because it dampens trading. The
launch of the euro is a good example of the desire to eliminate exchange
rate uncertainty and risk among countries.
In their 1989 Minneapolis Fed Annual Report essay,
Arthur J. Rolnick and Warren E. Weber argued that the floating regime
was an unmitigated failure—not only were exchange rates more volatile
and unpredictable, but the system also failed to correct economic fluctuations
and trade imbalances as advocates promised. This was reason enough to
consider going back to a fixed exchange system.
Laffer agreed that a fixed exchanged rate offered some useful advantages,
including eliminating the deadweight loss of transaction costs—a
dollar today buys the same number of yen tomorrow. "That is a real
beneficial effect of not having those transaction costs," Laffer
said. But he stopped short of advocating for a change. "If the
best monetary system could run it, it'd be great." But a fixed
exchange system controlled by ill-equipped and undisciplined countries
"will kill you."
Truman, of the Institute for International Economics, acknowledged the
warts of today's floating regime, saying it was "a bit like democracy."
Although it can lead to pricing and competitiveness problems for manufacturing
and other sectors, "it's probably the best. But that doesn't mean
But the jury is still out. At this point the burden of proof lies with
the floating exchange rate system, if only because that system is in
place. Advocates have argued that the long run will prove their point,
but the floating system has been running for quite some time now. How
much longer before we know?