The Willy-Nilly Dollar
Since the 1970s, currency values have been swinging wildly, with immense impact on economies and lives. Just since 1999, the dollar has moved from $1.17 per euro to $0.83 in 2001, and to $1.27 today, matching moves in the dollar's value in terms of gold and commodities. The impact of this volatility on U.S. farmers and manufacturers, developing countries, tourism, and investment flows has been immense and disruptive.</br></br>At last weekend's G7 meeting, the powerful group of finance ministers and central bankers accepted this, asserting that exchange rates should be flexible and reflect economic fundamentals. The U.S. hopes the G7 language will form a lasting consensus and be viewed as a set of long-term currency principles. But there's a hitch: Rather than "reflecting" fundamentals, the exchange rate is itself a key fundamental. It affects capital flows, jobs, inflation, and interest rates. Currency changes harm the relationship between debtors and creditors and dominate the profitability of many companies.</br></br>Without considering the exchange rate, there is not even a ballpark economic definition of a country's fundamentals -- one can't tell whether monetary policy is tight or loose, or inflation likely to rise or fall. If the idea is that strong economic fundamentals cause a strong currency -- as the Clinton administration argued -- it is unclear why the Bush administration seems so comfortable with the two- year weakness in the dollar. It surely doesn't agree with the dollar- bears' claim that U.S. fundamentals have deteriorated substantially due to the tax cuts and fiscal deficits.</br></br>My view is the opposite. U.S. fundamentals are much better now than in 2000, in large part due to the change in the value of the dollar and the improved tax structure. The fundamentals are reflected in important new records in GDP, total employment according to the household survey, corporate profits, productivity and disposable personal income. The U.S. potential growth rate in coming years is one of the best on record, and hard to explain if the current value of the dollar is thought to "reflect" economic fundamentals.</br></br>The irony in the fascination with the G7's exchange-rate language is that the causal relationship from economic fundamentals to currencies works so poorly. The dollar reached its peak value in 2001 after the recession started. Dollar strength wasn't the sole cause -- lax regulation plus high tax rates, interest rates, and oil prices contributed -- but the dollar certainly didn't reflect U.S. fundamentals.