Political Economy: Had Enough Yet?

CQ WEEKLY
June 2, 2008

By John Cranford, CQ Columnist

It should come as no surprise that the U.S. dollar has almost never been weaker since it lost its mooring to gold back in the Nixon administration. It’s true when you look at one of the world’s youngest currencies, Europe’s euro, which rose to an all-time high against the dollar a bit over a month ago. It’s also true when you look at one of the oldest, the British pound, which hit a 27-year high against the buck in November.

The dollar has been on a long slide since February 2002, and one economic consequence of that — higher prices here — has crept into the public consciousness. Nowadays, it isn’t just American tourists beefing about the price of a vacation in France. Nor is it just a case of wounded pride that the dollar isn’t winning the World Series of exchange rates these days. People everywhere seem to understand at some level that the United States is facing a currency-driven inflation threat.

That everyone knows the dollar is weak is clear from public interest surveys. A Bloomberg News/Los Angeles Times poll two weeks ago found that 76 percent of Americans want the federal government to do something to halt the dollar’s slide. A Gallup Poll earlier in May showed a majority of those surveyed regard the dollar’s weakness as a “major problem” on top of 29 percent who regard it as a crisis.

It’s not at all clear, however, that most Americans really understand what the relative value of the dollar means for them or the U.S. economy.

First off, there’s a very close correlation between the price of oil and the dollar-euro exchange rate. They move together about 95 percent of the time, which suggests that as the dollar weakens, the price of oil rises at a commensurate pace. Yet only 4 percent of those surveyed by Gallup last month cited the dollar’s decline as the reason gasoline prices were rising.

Second, it’s evident to most economists that there is a strong correlation between the prices of imported goods and the relative value of the dollar. Import prices for all goods have been increasing this year at the fastest pace in a generation — up more than 15 percent in April over a year ago. Even when petroleum products are excluded, import prices jumped more than 6 percent in April, the biggest year-over-year gain since 1988.

What is less certain is that import prices feed directly to the retail costs paid by consumers. But even if the link is imperfect, it’s clear that the cost of everything is being pushed up at least somewhat by the weakness of the dollar (if only because the cost of transportation is higher).

So, Americans are right to a degree when they blame the falling dollar for their seemingly shrinking paychecks. But before anyone demands the head of Treasury Secretary Henry M. Paulson Jr., it’s worth remembering that not too many years ago most of America’s big manufacturers were calling for the Treasury to let the dollar fall from what was by some measures a historic high point so that buyers around the world could afford their goods.

And economists were warning that market forces would knock the legs out from under the U.S. currency if we didn’t get our economic house in order. Well, guess what? Exporters got their wish and there are signs that the trade imbalance is righting itself.

On the Plus Side
The news that the economy expanded at a minimal 0.9 percent annual rate in the first three months of the year needs to be put in perspective: The United States is still buying far more overseas than it sells. But the trade deficit is narrowing, and that is counted as a boost to gross domestic product. Were it not for that improved trade picture, there would have been almost no economic growth in the first quarter, and the falling dollar gets most of the credit.

In fact, trade has been a net plus for GDP in five of the past six quarters, and the economy hasn’t gotten so much benefit from rising exports and declining imports since the early 1990s.

The change in direction on trade is likely to continue for a while, even if the dollar halts its decent. And that may be happening.

When measured against other currencies that are valued by the amount of trade each country has with the United States, the dollar was lower in April than at any point since late 1995. When that measurement is adjusted for inflation, the dollar’s relative strength two months ago was about a percentage point from its all-time low.

In May, however, the trade-weighted value of the dollar rose just a bit. Expectations that the Federal Reserve has stopped cutting interest rates — and might actually push rates higher before year’s end — seems to be encouraging some international investors to give the dollar second look. And even if the U.S. economy is in a slump, the rest of the industrialized world appears less vigorous than it did, which makes the United States look a bit better in relative terms.

So, the U.S. currency’s sustained decline appears to have been braked for the moment, though market forces — and a worsening economy — could send it lower again. At the same time, there seems little likelihood of the dollar rebounding in a big way anytime soon.

For now, then, we’ll have to bank on exports, cross our fingers on inflation and put those overseas travel plans on hold.