After Saddam’s capture, U.S. stocks actually declined slightly, as did the dollar. The euro–which was worth only 86 cents in early 2002–inched up to what was then a record $1.23. The actual changes didn’t matter much, but they reflected a simple reality: finding Saddam, though critical for Iraq, barely altered the powerful money flows now moving global stock, bond and currency markets. What’s occurring is a turnaround from the patterns of the late 1990s, when foreign money poured into the United States, chasing the Internet dream and rising stocks. From 1998 to 2000, foreigners invested $2 trillion in U.S. securities (stocks, bonds) and companies, reports the Federal Reserve. The flood of money pushed up the dollar’s exchange rate, as other currencies were sold for dollars. Now the cycle is reversing.
Although global investors aren’t withdrawing funds from the United States, they’re wary of new commitments. “What is striking is how unwilling foreigners are to add to their exposure of U.S. [stocks],” reports Merrill Lynch. It surveyed about 300 global investment managers for pensions, mutual funds, insurance companies and hedge funds. A surprising 58 percent thought U.S. stocks were already “overvalued.” Only 12 percent preferred American investments to those in Europe, Japan and elsewhere; 56 percent thought the dollar would depreciate over the next year.
What this means is that the rest of the world is receiving, through U.S. current account deficits, more dollars than it wants. So, the dollar has already been slipping on foreign-exchange markets. Since early 2002, it’s down about 30 percent against the euro, 19 percent against the yen and 23 percent against a basket of 26 currencies. This matters–and not just for Americans. The United States remains the world’s largest trading nation; in 2002, American exports and imports totaled almost $2.4 trillion. A high dollar makes U.S. exports more expensive and imports cheaper; a low dollar does the opposite. The dollar’s exchange rate affects the competitiveness of U.S. industries and also of European, Asian and Latin industries.
It’s a big deal that could get bigger. Fred Bergsten of the Institute for International Economics thinks the U.S. current account deficit needs to drop by half. It’s now 5 percent of gross domestic product (GDP). Getting to 2.5 percent of GDP will require, Bergsten says, another 15 to 20 percent decline in the dollar. What does a sliding dollar mean for the world economy? Here are three possibilities:
First, the United States wins–and no one else loses. A falling dollar spurs the U.S. economy by increasing exports and restraining imports. Surplus industrial capacity keeps inflation low. But Europe and Japan don’t suffer much, because the ongoing global economic recovery gathers strength and cushions export losses. Indeed, the pressure on their exports–from shifting exchange rates–prompts policy changes to raise domestic growth. Europe cuts interest rates; both liberalize markets.
Second, the United States and China win–and Europe and Japan lose. Because China keeps its currency, the renminbi, fixed to the dollar, it also gains competitive advantage when the dollar drops. (China stabilizes the renminbi by investing surplus dollars in U.S. Treasury securities rather than selling them for local currency.) Meanwhile, a sharp rise of the euro to, say, $1.40 depresses Europe’s exports and destroys its economic recovery. Protectionism rises. Japan suffers a similar fate.
Third, the dollar “crashes”–and everyone loses. Foreign investors sell U.S. stocks and bonds, whose values are weakening in terms of their currencies. (In mid-2003 they owned about 10 percent of U.S. stocks and 17 percent of U.S. corporate bonds.) This triggers massive selling. Stocks and bond prices drop sharply, as does the dollar. Americans and foreigners suffer huge losses. Confidence crumbles; the global economy slumps. “There are two risks [of a rising dollar]: one is that it creates a European slowdown; the second is that it upsets financial markets,” says economist Desmond Lachman of the American Enterprise Institute.
Little wonder that Saddam’s capture was an economic blip. Whatever effects it had on confidence are swamped by the uncertainties of the dollar. No one knows what will happen. Indeed, it’s possible that a reviving American economy could bolster the dollar by rekindling foreign interest in U.S. securities. How this drama turns out will be a big story of 2004. The best ending would be so boring that no one notices.
