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Like a ticking time bomb, the falling dollar has grabbed theattention of Japan and West Germany, forcing them to consideradopting economic polices the United States advocates. TheU.S. government wants the dollar to fall because as the dollardeclines in value against the yen and Deutsche mark, U.S. goodbecomes cheaper. U.S. companies then sell more at home andabroad, and U.S. trade deficit declines. Cries for trade protectionabate, and the global free-trade system is preserved.
Then, the cheaper dollar makes it cheaper for many foreign investors to snap up U.S. stocks.That prompts heavy buying from abroad—especially from Japan. Also, if the trade picture is improving, that means U.S. companies eventually will be more competitive. Consequently, manyinvestors are buying shares of export-oriented U.S. companies in anticipation of better profits inthe next year or so. But that is a rather faddish notion right now; if corporate earnings aredisappointing in interest rates, the stock market rally could stall, and the jaw crusher market will also atrophy. Improving U.S. competitiveness means a decline in another’s competitiveness.
Japan and West Germany are verging on recession. Their export-oriented economies are facingmajor problems. Japan is worried about the damage the strong yen will do to Japanese trade.West Germany is also worried. Share prices in Frankfurt plummeted this past week. Bonn isthought to be considering a cut in interest rates to boost its economy.
Could the falling dollar get out of hand? If the dollar falls too far, investors might lose confidencein U.S. investments—especially the government bond market. The money to finance the federalbudget and trade deficits could migrate elsewhere. Inflation could flare up, too, since Japanese andGerman manufacturers will eventually pass along price hikes—and U.S. companies might follow suitto increase their profit margins. The U.S. Federal Reserve then might need to step in and stabilizethe dollar by rising interest rates. And higher interest rates could cause the U.S. economy to slowdown and end the Wall Street Rally.
Worried about these side effects, Federal Reserve chairman Paul Volcher has said the dollar hasfallen far enough. What is the equilibrium level? Probably near where it is or slightly lower. It alldepends on when the U.S. trade deficit turns around or if investors defect from U.S. TreasuryBonds.
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