The dollar has declined in value over the past several months, especially against the euro and the yen. But does this really matter to the U. S. economy and to investors? Views on the subject vary as widely as do the reasons for the dollar's decline. Some depend on whether you live in the United States and whether you think that the current account deficit really matters. While most of the market chatter centers on bilateral interest-rate differentials, the trade weighted dollar index (graph below) allows for comparison against a basket of currencies.

The briefest possible definition
The trade-weighted dollar is the foreign currency price of the U.S. dollar or the export value of the U.S. dollar. When the index rises, the dollar's value is increasing. This in turn makes it easier for Americans to afford imports but at the same time makes American exports more expensive to those in other countries. There are three major indexes that have been developed by the Federal Reserve. One is a broad index, which measures the dollar's value with 26 currencies, incorporating all of the countries listed for the two indexes below. A second index measures the dollar's value with the U.S. major trading partners - the eurozone, Australia, Canada, Japan, Sweden, Switzerland, and the United Kingdom. A third index measures the dollar's value against the currencies of nineteen other trading partners - Argentina, Brazil, Chile, Colombia, Mexico, Venezuela, China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand, Israel, Saudi Arabia and Russia. The three indexes use a common weighting scheme. Market shares of U.S. goods in foreign markets and foreign goods in U.S. and third-country markets are used to construct the currency weights. These weights are updated on an annual basis to incorporate trading pattern changes.

Is it a euro and yen problem or a dollar problem?
About three weeks ago the euro finally regained parity against the dollar. Some currency market watchers thought they were enjoying what they had long predicted - the Great Dollar Crash. But to their disappointment, the euro's strength has quickly fizzled into an anticlimax. And this despite anemic U.S. growth! The euro, launched at $1.18 on January 1, 1999, hit a low of $0.83 in September 2000 and again in July 2001.

The dollar has fluctuated nearly in lockstep with equities - rising in value when the Dow rises and vice versa (see graph below). But there are other reasons contributing to the dollar's decline. From the perspective of overseas investors, the dollar is vulnerable to even small changes in sentiment. With the current account deficit (that is, the balance of merchandise trade and services and investment flows with the rest of the world) set to top $450 billion in 2002, the United States needs to attract huge fund inflows every working day in order to prevent the dollar from falling. Investors and central banks do not necessarily have to sell the dollar for it to go down - all they have to do is slow their purchases of U.S. assets. In the 90's merger frenzy, for example, European companies were snapping up U.S. assets as a vehicle to gain entry into the seemingly insatiable U.S. market. These days are long gone.

In addition to the growing current account deficit, the dollar's difficulties are being exacerbated by the surging fiscal deficit. Since the end of 2000, the U.S. government has moved from a budget surplus approaching $300 billion to a deficit of close to $200 billion. While international fund managers are often prepared to finance private investment, they tend to be less willing to finance government consumption.

Another reason for the weakening dollar is the crumbling confidence in the integrity of U.S. corporate governance. This has reduced the willingness of international fund managers to increase their holdings of U.S. companies. Even if U.S. profit and loss accounts were trusted, U.S. equities still look expensive relative to others overseas. However, fund managers are also less than sanguine about possible irregularities overseas.

Lackluster growth worldwide doesn't necessarily give traders incentives to shift investments from one country to another. Last week currency traders were looking for positive U.S. news to exit their dollar positions. U.S. gross domestic product data disappointed, so traders followed equities. Safe-haven status is another factor behind currency movements. Terrorist attacks and a threat of an Iraqi invasion have investors searching for other safe havens such as gold and the Swiss franc when, in contrast to pre-September 11, only the dollar would do.

Parity
Symbolism is important in the currency markets and euro parity with the dollar is a very big symbol. When the euro fell through $1 in February 2000 it was a powerful blow to the prestige of the infant currency and a sign of the pre-eminence of the U.S. economy. The move back through parity is no less potent a symbol. What is more, some analysts fear that the dollar, now below the threshold of parity, may begin to fall violently. From the European perspective, the fall back through parity is an important sign that markets have lost faith in the magic of the U.S. economy, which has been the motor of the world economy for the past decade. The United States has spent years telling the rest of the world how to run their economies. Now markets are finally awakening to the problems of the U.S. economy.

In the short run, the recent rise of the euro is likely to be positive for the European Monetary Union economies, since it should lower inflationary pressure by making imports less expensive. That, in turn, helps the European Central Bank keep interest rates low, since it doesn't have to boost them to keep inflation at bay. In the longer term, however, weaker exports could begin to take their toll, especially on an export-dependent economy like Germany. Last year, net exports accounted for nearly half of the euro zone's economic growth.

Like Germany, Japan may suffer from a weak dollar. The decline in the yen earlier this year helped fuel exports, the key factor in the nation's limited growth. But the dollar, until its very recent stabilization, had been retreating against the yen amid worries about U.S. accounting scandals and declining U.S. stock prices. The impact on Japan may be immediate and painful. With Japanese interest rates already near zero and government finances in a mess, Tokyo has few tools to boost economic growth and has been counting on steady growth overseas, particularly in the United States, to give its exporters a boost.

Bottom line
So far, the erosion in the value of the dollar is considered a relatively positive event, both for the United States and other large economies. In the United States, it has given much-needed help to struggling exporters without kindling inflationary concerns. In the eurozone, it looks likely to postpone the need for higher interest rates. Some analysts argue that by making it harder to export to the United States, the dollar's fall could help promote faster structural reforms in Japan and the eurozone. An accelerated sell-off in the dollar, by contrast, would be more disruptive. Not only would a sell-off in the dollar further unsettle the U.S. stock market, it would make it harder for the eurozone and Japan to adjust to a higher exchange rate. Policy makers will be hoping that the dollar's fall will continue to be relatively sedate.

Forecasting foreign exchange rates is a high wire act. Conventional logic does not always apply. Despite a weak economy, the United States still is outperforming just about everyone else. Throughout all the gyrations in global financial markets since the mid-1990s, the dollar has been a beacon of strength for investors. Except for brief setbacks in 1998 and 1999, the currency has appreciated steadily over the past seven years. Even now, just when the dollar appears to be vulnerable, it has the capability of surprising.

Anne D. Picker, International Economist, Econoday