The US' current account deficit is ballooning, making the US the world's largest external debtor (only, of course, in absolute terms, as the US is far from the worst performer if the trade deficit is measured as a share of GDP). Yet despite huge and growing deficits, the dollar continues to soar. Although we have learned not to worry so much about falling stock markets, should we now worry about the US trade deficit and the almighty dollar? Indeed, isn't the dollar poised to sink simply of its own bloated weight?
Two things can bring the dollar down: loose talk from the secretary of the treasury, or a sharp deterioration in the US' relative economic performance compared to the rest of the world. Both risks have been tested this year. As a result, the dollar has vacillated. Both risks are now coming under control and so continuing strength for the dollar must be anticipated.
There are two kinds of US treasury secretaries. The first are like Robert Rubin and understand that a strong dollar helps secure low interest rates and that low rates make for a long and broad boom. The other kind is found in the current US Treasury Secretary, Paul O'Neill, who think too much about competitiveness and know too little about capital markets. They like intervention, industrial cartels, target zones for currencies and the sundry other gimmicks that got a bad name back in the woeful economic era of President Jimmy Carter.
Secretary of the Treasury O'Neill came into office from the world of manufacturing and so thinks like a manufacturer. But no matter how successful they were in their industry, manufacturers look at the economy from the rabbit hole up.
They think a weak dollar is good for exports and a hard dollar hurts sales and market share. Hence they wince when they face a strong dollar and offer wishy-washy answers to any question concerning their policy toward the dollar.
Secretary O'Neill, indeed, has been ambivalent about the dollar from day one.
Instead of looking journalists firmly in the eye and pronouncing Robert Rubin's reassuring mantra -- a strong dollar serves the US well -- he wavered! He could not get those words out of his mouth. So, in no time, the dollar started wobbling and even -- momentarily -- went down.
That situation was repaired when President Bush, presumably encouraged by Federal Reserve Bank Chairman Alan Greenspan, reiterated personally that the US seeks a market-determined value for the dollar. So forget about intervention to force down the dollar's value. As a result, the road remains open for more interest rate cuts from Greenspan's Fed to help restore economic expansion. Such a stance serves the US -- including manufacturing -- better than talking down the dollar's value to boost demand for US goods.
A second possible cause for dollar weakness -- a poor performance by the US economy relative to the rest of the world -- remains. But that risk, like Secretary O'Neill's careless tongue, is receding. The US has crossed the valley where risks of a major collapse were possible. An upswing is coming in the fourth quarter, underpinned by tax cuts and much lower interest rates. The coming year is likely to deliver 3 percent growth, the most to be expected in a still fully employed economy.
Can Europe and Japan do as well? Surely not Japan now; one is inclined to say, never. Europe, too, will not grow that quickly any time soon. That leaves us with the prognosis of a strong dollar for the coming year.
Argentina's debt problems may weaken the dollar a little and Turkey's difficulties may hurt the euro. Both issues, however, will only effect those currencies at the margins.
Of course, not long ago the newly created Euro seemed to pose as a serious competitor to the dollar. It is now clear that the Euro's launch was a failed IPO. Its price has crashed; exaggerated expectations for the Euro have unraveled.
Yet the Euro idea remains sound and the economic benefits will arrive one day. But a sound valuation of a currency demands a sharp look at the policies that support that currency. Here Europe still leaves much to be desired. European policymakers remain ambivalent about the use of markets and so their economies cannot stand up to comparison with the US' dynamism, not now and not any time soon. That limits the upside of the Euro.
True, the US cannot borrow abroad forever and one day the dollar and the current account will turn. But don't expect that turnaround soon.
A substantial workout has been underway in the US to correct the excesses of the Internet boom. Major investments in employment, tightened budgets and improved human capital have strengthened the economy, raising both its medium term potential for growth and its stability.
The US' long boom was no house of cards, no matter how hard those who scoffed at the New Economy wished it to be so. Beyond the hype we now see high employment and a stable economy.
Capital will keep going to the US because it offers the best prospect for profit, which will keep it as the world economic leader. So, whither the dollar? As of yet, there is no rival to the US or the dollar as far as the eye can see.
Rudi Dornbusch is a professor of economics at MIT and a former chief economic advisor to both the World Bank and IMF.
Copyright: Project Syndicate
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