The Declining Dollar: Not a Simple Cure

By Charles P. Alexander

The greenback must continue to fall, say many economists and now the Administration, if the U.S. is to curb its ruinous trade deficit. But no one can argue that such a strategy offers a simple and painless cure for America's economic ills. On the contrary, the perils are enormous and the effectiveness is uncertain. The immediate challenge for the Federal Reserve and the U.S. Treasury is to control the dollar's descent -- no easy feat -- and prevent a free fall, which would scare off foreign investors, drive up U.S. interest rates and perhaps cause another panic on Wall Street. But even a gradual decline of the dollar is no panacea. It will impose hardships on the U.S. economy that cannot be easily shrugged off, and it may not help nearly as much as Treasury Secretary James Baker and the economists believe.

The theory behind the benefits of a currency devaluation is textbook clear: if the dollar falls, the international prices of U.S. products drop, and foreigners will buy more of them. At the same time, foreign goods become more expensive in the U.S., and Americans will reduce demand for imports. A combination of the two trends will lower the trade deficit.

That, at least, is the theory. In practice, the mechanisms have been more complex and less effective. Since early 1985, the dollar has declined by about 50% against major currencies like the Japanese yen and the West German mark. Yet the U.S. trade deficit is as high as ever. Admittedly, it takes time for consumers and businesses to change their buying habits, and an improvement in the trade balance may be in the pipeline. But several forces are holding the deficit up. For one thing, foreign manufacturers have shown a dogged determination to hold down their U.S. prices to maintain market share, even if it means sacrificing profits. Conversely, many U.S. manufacturers have failed to take advantage of the weaker dollar to sell their products aggressively . overseas.

More important, price is not the only factor in international buying decisions. Many U.S. goods simply do not satisfy foreigners' tastes or meet their quality standards; these products will not sell overseas even if they become cheaper. By the same token, American consumers partial to Toyota cars, Krups kitchen appliances, Rossignol skis and Gucci shoes will not easily be discouraged by price rises. In the case of the videocassette recorder, American consumers have no choice but to buy foreign, since U.S. manufacturers do not make the machines. Indeed, as long as the American appetite for imports remains, a perverse effect takes place: as the price of foreign products increases, Americans spend even more dollars for the same volume of goods. Meanwhile, they earn fewer yen, francs and marks for U.S. products that do sell well abroad, like Boeing aircraft and IBM computers. As a result, the trade deficit actually increases in dollar terms.

Even if a prolonged decline of the dollar eventually reduces imports, the side effects will be unpleasant. One is higher inflation: as foreign products become more expensive, many U.S. manufacturers will jump at the opportunity to raise their prices too. A big danger is that the weak dollar will become a crutch for U.S. companies, undermining their incentive to become more efficient and hold prices down. Beyond that, the bargain-basement dollar, together with lower prices on Wall Street, may make U.S. industry increasingly vulnerable to takeovers by foreign buyers.

The ultimate impact of a continued devaluation will be a slowdown in the growth of American living standards, or an absolute reduction. But that may be the price of having run huge trade deficits year after year. Says Stephen Marris, an economist with the Institute for International Economics in Washington: "We are in a mess. There is no easy way out."

History does not offer much encouragement on the benefits of devaluation. The British pound and Italian lira dropped during much of the 1970s, while the West German mark and other Continental currencies rose. Yet at the end of the decade West Germany was enjoying a massive trade surplus and manageable inflation. Britain and Italy, meanwhile, languished under trade deficits and double-digit inflation. Sir James Goldsmith, the British financier, witnessed the process firsthand. Warns he: "Like drugs, devaluation gives you a breather, a small kick. Then it becomes an inflationary merry-go-round to , hell." Only when Britain began pumping large amounts of North Sea oil in the late 1970s did its fortunes improve.

In contrast, countries with strong currencies have been able to boost their living standards. The mighty mark and yen have been putting a burden on West German and Japanese exporters, but they have responded by holding down costs and becoming more efficient. One reason they can do so is that many of their imported raw materials and components are priced in dollars and have become cheaper. With greater price stability, Japan and Germany face less pressure for wage increases. Despite the strong mark, Germany has become the world's leading exporter. Japan is openly contemptuous of the notion that the U.S. can solve its problems through devaluation. Says Johsen Takahashi, chief economist of the Mitsubishi Research Institute: "Letting the dollar slip now is like spitting up into the sky." Another Japanese economist is equally blunt: "America is no longer in control of its own currency."

If the U.S. is to regain control of its economic destiny, it will have to do far more than let its dollar fall. A weakened dollar is no substitute for forceful action to reduce the budget deficit, which would not only ease demand for foreign capital and imports but show that America had the political will and leadership to put its house in order. Nor will a devaluation remove the need for U.S. manufacturers to improve their quality and efficiency and learn how to promote their products in foreign markets. A gradually declining dollar may be a painful necessity now, but the U.S. should never lose sight of the goal of any prosperous trading nation: to be able to sell abroad and still have a currency strong enough to buy a lot in return.