Dollar Rises to Challenge the Orthodoxy
Only a few months ago, it was common to hear that the only thing holding the dollar up was massive buying by foreign central banks. On April 18, for example, a typical article in a British journal suggested that in the preceding year, Treasury Secretary Baker "has taken out balance of payments insurance by persuading foreign central banks to suppress an upsurge of American interest rates by purchasing nearly $200 billion of U.S. securities" (emphasis added). If the central banks ever stopped financing our trade deficit by buying Treasury securities, the experts agreed, then the dollar would drop by 30% and interest rates would soar.</br></br>Now, however, foreign central banks are not only not buying dollars, but instead selling billions. Yet the dollar nonetheless remains quite strong, and U.S. bond yields have gone down, not up. If it really required $100 billion to $200 billion of intervention to prop up the dollar, how can things have suddenly changed so much? Much credit for the dollar's firming is given to recent dramatic narrowing of the monthly trade-deficit figures. But in actual dollar terms, that is not the big story.</br></br>What has changed in the first half of 1988 appears to be mainly the capital account (investment) rather than the current account (trade). Americans are investing less abroad, leaving fewer foreign transactions to finance by selling dollars, while foreigners are investing more in the U.S., and thus buying dollars to finance those investments. The U.S. is clearly looking relatively more attractive to world investors. Bond prices have recently increased in the U.S., but fallen in Germany, the U.K. and Japan. Stock prices are also near this year's peak in the U.S., but the largest foreign stock markets are well below their peaks when measured in U.S. dollars.</br></br>Of course, the dollar's rise and the improved picture for U.S. investments are mutually reinforcing -- it is hard to pinpoint where the chicken-and-egg cycle began. But by itself, the stronger dollar should take some competitive pricing pressure off the industries of countries such as Germany and Japan, thus helping their stocks. So, the fact that their markets nonetheless remain much weaker than those here, when measured in the same currency, indicates that discounted profit opportunities look stronger in the U.S.</br></br>The U.S. is not alone. Canada, Australia and, until recently, the United Kingdom all experienced sharp increases in both their currencies and stock markets this year, relative to Continental Europe. Interestingly, Canada and the U.S. both reduced marginal tax rates in January, while Australia announced lower tax rates for the near future. The British pound first soared on the news that the top tax rate would soon drop to 40% from 60%, but there has since been considerable uncertainty about new taxes in both Britain and Germany.