A Strong Dollar Looks Likely, but Not Certain, for 1991

THE dollar has been strong against the yen and the German mark since the ending of the Gulf war. Why? And what might this mean for American competitiveness? Often the public looks on foreign exchange rates the way it looks on football contests. If American military technology proved to be fantastic in ending the Gulf war quickly, completely, and with minimal deaths for coalition fighters, then the United States is the new Rome at turn of the century.

According to this point of view, the recent appreciation of the dollar relative to the Common Market currencies and the Japanese yen is quite understandable. And so long as America rides the wave of diplomatic success, speculators who are bullish on the dollar will garner capital gains in the months to come.

I hate to spoil a dramatic story. But in my view as an economist, exchange rates do not belong on the sports page. Nor for that matter do they belong on the editorial pages, where pundits apply the wisdoms of a Clausewitz or Machiavelli, Talleyrand or Kissinger.

What determines how the dollar will move are the mundane forces of supply and demand. Enthusiasm and mood shifts can move markets for a few weeks or so. But all the interventions of the Group of Five or Group of Seven industrial nations cannot hold down the dollar if cool money finds it can earn a better return from assets here than from assets in Europe and Asia.

Therefore I must survey the newest economic trends.

I begin by reporting the recent change of mind by Rudiger Dornbusch, the Massachusetts Institute of Technology's respected expert on international finance in Europe and Latin America. Dr. Dornbusch, along with Harvard's Martin Feldstein, was a long-time bear on the dollar. He correctly predicted its sustained drop from the 1985 peak.

Every two months Dornbusch prepares a private Economic Letter that is read by inside experts all over the world. Now Dornbusch has dropped his near-term bearishness. Instead he expects the dollar to stabilize until next autumn. After that it can be expected to rise.

Why this sea-change of opinion? Cold economics and not hot politics shapes the Dornbusch outlook - and quite a few other authorities share his viewpoint.

In a nutshell, all these experts accept the fashionable view that the American recession is on its way out. By summer, the US economy will be on the rise.

Once production rises and unemployment stops growing, the Federal Reserve can be expected to let our interest rates rise. That will strengthen the dollar.

Last year, America was the first to go into recession. This year Italy, Spain, France, Japan, and maybe even Germany, will lag behind the American recovery. When the Bank of Japan and the European central banks are easing interest rates, that will further support the case for a strong dollar in 1991.

Where do I stand in this debate?

1. The White House and America's consensus forecasters may well be right that the recession of 1989-90 will be mild and short-lived.

2. Victory against Iraq has buoyed consumer optimism and the low price of oil does remove a supply shock.

3. Yes, the level of inventories here looks to be well controlled rather than displaying the swollen excesses of previous deep recessions.

4. Yes, the New York stock market did rise by more than 25 percent since its 1990 low. Maybe Wall Street investors are correctly discounting the recession's early end.

5. Yes, the Federal Reserve did ease credit to fight the recession.

For the above reasons and more, bet with the optimistic experts.

Still, economics is not an exact science. I would counsel that you reserve 25 percent of your probability expectations for the contingency that America's recession will last well into the last half of 1991, and will end up being nearly as severe as the 1973-75 and 1981-82 recessions.

Here is why one's prognosis must be guarded and cautious.

The automobile and the construction industries loom large in the US economy and, as yet, neither one shows significant recovery.

Inflation has not yet ceased to be a threat. The Federal Reserve may therefore be unwilling and/or unable to engineer lower long-term interest rates.

Several hundred banks remain insolvent and will probably fail. A credit crunch, in which loan officers of banks continue to ration funds severely, even to good credit risks, must still be regarded as a threat.

The upshot is this. America's neighbors abroad ought still to recognize 1-to-3 odds that our own recession will persist into the autumn, interest rates will therefore weaken here, and cool money will be loath to buy dollars and therefore dollar weakness will return.

A final warning is in order.

Dollar weakness will be a good thing and not an evil if the US economy turns out to need stimulus from brisker exports.