Originally published in The Boston Globe
Tuesday, April 24, 2001

The Strong Dollar Puzzle
By Martin and Kathleen Feldstein

"It looks as if investors are ignoring the fundamentals and buying currencies
on the basis of the country's growth rate."

The recent strong value of the US dollar relative to the currencies of our major trading partners has been a mixed blessing, as well as a puzzle to experts in international economics. US goods have become relatively more expensive than comparable goods produced abroad as the dollar rose by 10 percent over the last twelve months. The higher US prices paid by both US and foreign buyers has worsened our trade balance by encouraging Americans to increase imports from the rest of the world while the volume of our exports has actually declined.

The US merchandise trade deficit has risen to an annual rate of more than $450 billion, or about 4.5% of GDP. History, as well as economic theory, shows that this kind of trade deficit is not sustainable. The main mechanism that will shrink the trade deficit will be a decline in the value of the dollar relative to the currencies of out trading partners. Although no one can be sure when that will happen, it's a pretty good bet that the dollar will eventually decline from its current high level.

Even more surprising than the overall strength of the dollar is the relative weakness of the euro, the new common currency of 12 countries of Western Europe. The euro came into existence in January of 1999 and soon reached a value of 1.16 euros for each US dollar. Although Europe does not have a significant trade deficit, the euro has fallen since then by more than 20% to less than 90 US cents at the present time.

The big puzzle is why financial investors in the US and abroad want to put their money into dollars that they know are likely to decline in value.

One plausible explanation would be a rate of interest on dollar bonds that is sufficiently higher than the interest rate on comparable European bonds to compensate investors for the expected fall in the value of the dollar. But that is simply contrary to the facts. The interest rate on US bonds is only slightly higher than comparable European rates, certainly not enough to offset the likely speed of the dollar's decline. And the latest Fed rate cut could drive US interest rates below those in Europe.

Another explanation for the relative strength of the dollar might be the desire of investors around the world to have a stake in US equities. Again, this seems unlikely in the current highly volatile US stock market environment. Further, the flow of investment into US stocks from the rest of the world has been balanced by equally large flows of equity dollar from the United States to the rest of the world.

A final possibility would be foreign borrowing to finance direct investment such as mergers and acquisitions or the purchase of US real estate. Although that has been a major source of demand for dollars in the past year, it is hard to see that continuing in the future. And it doesn't explain why foreign investors don't simply borrow the funds in the US that they need.

The puzzle is only compounded by the declining interest rates that the Fed has engineered in recent months. Those reductions in interest rates should have made US investments less rewarding, which should have reduced the demand for US dollars and therefore led to a lower exchange rate. But the opposite has happened.

It looks like financial investors are ignoring the fundamentals like the interest rate and the trade deficit and buying currencies on the basis of the country's growth rate. Even if this strategy makes money for currency traders in the short run, it defies logic and must be corrected over a longer period of time.

In the meantime, the strong dollar has had benefits for the US economy. It has kept down import prices and therefore has raised the purchasing power of US incomes. It has helped to offset inflationary pressures, making it easier for the Fed to focus on sustaining demand and economic activity.

But try telling that to the manufacturing firm that has to compete with imports from Europe that have gotten 20 percent cheaper over the past two years or with the Japanese goods that have become 50% cheaper. It is hard to deny that the strong dollar has at a minimum exacerbated the slump in the manufacturing sector that began last year.

The major worry about the inevitable correction to the overvalued dollar is the risk of a sharp decline when the pendulum swings and the market for the dollar begins to soften. A slow and gradual decline would be a welcome correction. It could breath new life into internationally exposed manufacturing firms and reduce the extent of imbalance and the accompanying fragility.

But a sudden and steep drop in the dollar could mean a surge in inflation and a sharp rise in interest rates. With the US economy already slowing, those higher interest rates would hit housing and other construction hard, as well as business investment and consumer durables.

There is little the Fed or the Administration can do either alone or in cooperation with the European banking authorities to adjust the value of the dollar in an orderly way. Along with the rest of us, they can only hope that the dollar adjusts soon to a level consistent with a much smaller trade deficit.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.