Why the world frets over the dollar's fall

During a dollar crisis in the 1970s, Treasury Secretary John Connally told his European counterparts, "The dollar's our currency; but it's your problem."

There's still a lot of truth in that today. The reaction abroad to the current drop in the greenback's value differs sharply from that in the United States. Japanese and European officials reportedly have already talked behind the scenes about intervening in foreign-exchange markets to prop up the dollar.

But last week's leak to the press may not materialize in real action unless the dollar falls rapidly - or reaches really low levels. So American consumers will shell out more for foreign cars and toys and trips abroad.

Since a recent peak in February 2002, the dollar has fallen an average of about 15 percent against the currencies of the key trading partners of the US. That has prompted loud complaints in Europe, where businesses worry that their exports, priced in more expensive euros, could become uncompetitive. Economic growth could stall.

But here in the US, Treasury Secretary John Snow appears blasé. The administration has given no hint it will use its $82 billion stash of foreign-currency assets to support the price of dollars by buying them on foreign-exchange markets. "Nobody cares in Washington," says consulting economist David Hale in Chicago.

Three decades ago, some foreigners interpreted the dollar's fall as symbolic of a decline in US economic and political status. Today with the invasion of Iraq, it's sometimes seen as signaling an overextension of America's resources abroad. But "it's all nonsense," says David DeRosa, a Yale University finance professor. "It's simply an adjustment in price" of the dollar.

While Mr. Hale sees a "small" loss of US prestige in the dollar's decline, he's more worried about the loss of confidence in the dollar continuing and getting worse.

Confidence is important. Over the past 10 years, America has been the place to invest. Foreigners poured $6 trillion into US financial markets. That's $1 trillion more than the growth in the US gross domestic product in that decade. Private investors hoped for a better return than they could get in Europe, with a lackadaisical economy, or in Japan, with a flat if not a recessionary economy. That investment flood was a key factor in the dollar's strength - until the last year or so. But with soaring budget deficits and a $620 billion deficit in the US current account (the trade balance plus some investment flows) this year, private investors have become more cautious about sending money into the US.

That has put more pressure on foreign central bankers - the Alan Greenspans of the rest of the world - to step up to the plate. Will they buy more dollars so their own currencies don't rise too much? Or will they sell their greenbacks because their value is falling?

The response, so far, illustrates how topsy-turvy the world of central banking can be.

Some usual US partners have decided to trim dollar losses. Canada, Australia, and New Zealand have already reduced the dollar share of their foreign-exchange reserves to less than 50 percent, compared to a global average of 66 percent, says Hale. "Our traditional allies have abandoned the US dollar."

Meanwhile, our chief Asian economic competitors - Japan and China - have stepped in over the past two to three years to prevent their own currencies from rising.

By now, Japan has amassed $817 billion worth of foreign currency, mostly dollars. But it too has thrown in the towel - at least for now. It stopped supporting the dollar this past spring, letting the yen rise.

China has the second largest pool of international reserves, some $600 billion. It is still pegging its own currency, the yuan, to the dollar at a fixed rate, and thus is accumulating more dollar assets.

Major foreign nations won't find it so easy to bail out of dollars as smaller countries do. If China's central bank, for instance, decides to use some of its surplus dollars to buy euros for its reserves, it further depresses the dollar - and the value of its dollar reserves. Further, no other capital market is so huge and liquid as that of the US. China or Japan could have trouble selling large amounts of dollar assets. The euro market can accommodate billions of dollars in a transaction, but not tens of billions, notes Richard Cooper, a Harvard economist. And Japan's financial market is relatively small and offers even lower yields than the US market.

In any case, it's not clear that central bankers worry much if their dollar assets are devalued. Prior to the creation of the euro in 1999, a common currency for 12 European nations, the Austrian central bank simply revalued its gold holdings upward to cover a capital loss, in its books, on its dollar-denominated assets.

But if the pressure on the dollar builds into a rout and thereby pushes up US interest rates, American benign neglect may fade. The Federal Reserve, with the backing of Treasury, could then invite other nations to help save the dollar. There will be "willing cooperators" around the world, says Professor Cooper.