Issue: March 2005
By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research

"It’s our currency, but it’s your problem" —  U.S. Treasury Secretary John Connelly

Secretary Connelly was a blunt talking Texan who after listening to a litany of European complaints about a falling dollar back in the early 1970s, encouraged the Europeans to do something about it. The US economy was outgrowing its European counterparts and drawing in a lot more in imports than it was exporting to the weak economied Europeans. The result was a declining dollar.

With the economy in full recovery, the pessimists around us have to find another thing to worry about. These days, the decline in the value of the dollar seems to be the bete noir of choice. Instead of wringing our hands over the dollar’s decline, we should be cheering. As was the case 30 years ago, the US economy is again outperforming its European counterparts. Again, the US has a sizable trade deficit. And again, the US dollar is under pressure. As the French would say, plus ca change, plus c’est la meme chose.

The great fear is that seeing a declining dollar, foreigners are going to stop investing in the US economy. If foreign investment dries up then the dollar drops sharply and interest rates soar. For the pessimists in the crowd, this combination of events will push the economy over into a recession. The solution to this problem, from the point of view of the pessimists, is to increase aggregate savings through tax hikes and reduced consumer spending. If the US can slow economic growth to the tortoise pace of the Europeans or Japanese, then our trade balance will begin to right itself.

Over the years, the dollar has had its ups and downs. The dollar soared between 1980 and 1985. Tax reduction, economic deregulation and strong US economic growth brought a large US trade deficit and a surge of foreign investment, particularly Japanese money that was being spun out of the deregulation of the Japanese financial system. 

The sharp decline in the dollar between 1985 and 1987 was of much greater magnitude and duration than the current slide. It was driven in large part by a slow down in foreign investment from low triple digit to high single digit growth. During this period of dollar decline, even though interest rates rose, the economy continued to expand and foreigners still brought their investment dollars to the US.

This period of sharp dollar decline ended in the 1987 with the stock market crash but even that event did not stop the flow of foreign investment into the US. Even more to the point, the dollar continued to decline for another 8 years, albeit in a more orderly fashion, and that did not seem to have much impact on foreign investment in the US. Only the recession year of 1991 saw foreigners take money out of the US economy. The economic lesson here is clear, the lack of real growth, not trade imbalances or even the dollar’s value are what deter foreign investment.

Over the past three years, as the dollar declined, foreigners continued to put money into the US economy. Foreign investment slowed through 2004 but in recent months is showing signs of picking up. 

Foreign investors can always sell, but at the end of the day, the US economy is far and away out performing other developed country economies and that is what drives foreign investment more than anything else. No other country has the combination of pro-business tax, labor and environmental climate coupled with a highly educated and mobile work force. Although foreign banks have dropped hints that they would like to reduce their holdings of dollar assets that is not something that they are likely to announce before doing. What is more likely is that they are trying to talk down the dollar so as to get a better price for future dollar investments.

While the pessimists would like to see higher taxes and a slowdown in the US economy as a solution to the dollar and trade imbalances, a much better solution would be to encourage faster growth outside of the US. The large US trade deficit is giving a boost to otherwise anemic European and Japanese economies. At the same time, the declining dollar is making oil cheaper for the Japanese and Europeans and should actually help their economies. As such, the decline has to be viewed as a positive for the global economy, worth at least a cheer or two.

Based in New York, Carl Steidtmann is Deloitte Research's chief economist and a director of Consumer Business Research.  In 2003 Dr. Steidtmann was selected as one of the 25 most influential consultants by Consulting Magazine for his work in consumer spending forecasting. He earned his Ph.D., master's and bachelor's degrees from the University of Colorado.

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