The Mysteriously Strong Dollar.

• Author: KARCZMAR, MIECZYSLAW
• Position: Statistical Data Included

Why the greenback keeps defying predictions of its imminent fall.

It has been more than six years since the dollar embarked on the rising trend. Since its low point in April 1995, the dollar has risen 68 percent against the D-mark, 55 percent against the yen, and 45 percent in trade-weighted terms, reaching its highest level in sixteen years. For most of this period, rising dollar trend coincided with the U.S. economic boom. Hence, most analysts were attributing the dollar upswing to cyclical reasons as reflected in favorable growth and interest rate differentials. This has not been a satisfactory explanation, however.

In the four years preceding the beginning of the dollar's rise, the U.S. economy was also expanding (though less vigorously) while Europe was growing more slowly and Japan was largely stagnant. But the dollar was falling sharply during that period. Furthermore, the U.S. economic boom ended a year ago. Consequently, both growth and interest rate differentials moved against the dollar, the U.S. equity markets slumped, corporate profits plunged, and the trade deficit reached a record high. Yet the dollar has remained strong and kept rising against all major currencies, contrary to conventional wisdom and most economic predictions.

The dollar/euro relationship is a special case in the strong-dollar puzzle. The euro was launched two and a half years ago amid great hopes and expectations that it would soon become a global currency that would challenge the dollar. Many economists had predicted that it would appreciate strongly from its initial parity rate of $1.17 due to massive portfolio and monetary reserve shifts from the dollar area.

This has never happened. On the contrary, the euro fell sharply to 82 cents in October 2000 and has settled down in the 86-90 cent range, a one-quarter depreciation since its inception. Importantly, the euro kept falling even after the U.S. economy moved into a pronounced slowdown bordering on a recession, thus contradicting the popular view that it would appreciate because Euroland would be insulated from that slowdown.

What were the reasons for that disappointing euro behavior? Some economists, most notably Robert Mundell, the intellectual godfather of the euro, contend that the reason was excess liquidity resulting from the pooling of monetary reserves of the member countries. Others blame the lack, or a very slow progress, of structural reforms the new currency was supposed to trigger. Still others point to the fact that the euro is still a virtual currency and that the forthcoming introduction of euro notes and coins is causing a flight of illicit money into dollars.

All these factors may have contributed to the euro's decline. But the main reason was the performance of the European Central Bank (ECB). It has failed to establish its credibility as a truly independent bank, as provided for by the Maastricht Treaty. Its top officials have been talking with different and sometimes contradictory voices; at various times one could detect political interference in its policy decisions. Above all, whether by neglect or design, the ECB has kept the euro undervalued. This helped improve Euroland's export competitiveness but defeated the original raison d'etre of the euro as conceived by Charles de Gaulle over forty years ago--to compete with the dollar as a global investment and reserve currency.

The euro's weakness and its reasons only partially explain the strength of the dollar, which has risen against all currencies. What are the main reasons for the continuing dollar strength despite the apparent turn in the American business cycle? And why did most economists fail to predict this strength? There are two main reasons: first, a lack of recognition that the dollar is a unique currency because of its global characteristics and the impact of the American economy on the rest of the world, and second, the failure to pay enough attention to the U.S. government's foreign exchange policy and the related psychology of currency markets.

The best illustration of the first of these two factors is the U.S. balance of payments. The coincidence of the strong dollar and rising external deficits is the most puzzling aspect of the dollar saga. From 1995 to 2000, when the dollar appreciated over 40 percent, the U.S. current-account deficit nearly quadrupled. Moreover, last year the deficit reached the highest level ever, both in absolute and relative terms (4.5 percent of GDP), and there are no prospects for an improvement this year. In fact, 2001 will be the twenty-sixth consecutive year of trade deficits and the twentieth year of current-account deficits. (The United States had a small current-account surplus in 1991, but it was an extraordinary event related to payments of several foreign countries as their contributions to finance the Gulf War.) Any other country that would have such large and rising external deficits for such a long period would have seen its currency dropping, but the dollar rose. The reasons lie on the financing side of the balance of payments (the capital account).

A country can run a balance-of-payments...