Evans On The Economy -- Dollar Dilemma

Most of the commentary about whether the U.S. economy is about to recover is based on what is happening to consumption, housing and capital spending. However, one of the most striking features of the current downturn has been the plunge in exports, which fell an estimated 11% last year. Furthermore, even if domestic demand turns around quickly, exports are likely to continue to decline. Part of this drop is due to weak demand around the globe, but an even more significant factor is the dollar, which is now overvalued by about 20%. Every year, the Bureau of Labor Statistics (BLS) publishes data on manufacturing production worker labor costs as a percentage of U.S. costs. The latest BLS results for 2000 were published last September; I have updated these figures to 2001. The results for key benchmark years for major OECD (Organization for Economic Cooperation and Development) countries are given in the table below. A 79 for Canada in 2001 means labor costs for manufacturing production workers in Canada are 79% of similar costs in the U.S., measured in U.S. dollars. Thus, relative to our major trading partners with roughly comparable technology, last year the dollar was overvalued relative to Canada and Euroland and almost even with Japan. However, those figures are based on 2001 average currency rates. Recently, the dollar has strengthened considerably. Based on current exchange rates, the dollar is now overvalued by 31% relative to Canada, 14% for Euroland and 11% for Japan. Hence on an overall basis, the dollar is currently overvalued by about 20%. Given this development, there is little surprise that exports have recently been depressed, and will remain very weak during the rest of this year. The dollar was even more overvalued in the mid-1980s, and the U.S. economy survived that experience. However, real interest rates were at near-record levels, and about to return to normalcy. Today, short-term interest rates are at rock-bottom levels, and the trend over the next few years is clearly in the upward direction. Hence there is no relief in sight for the overvalued dollar from lower U.S. interest rates. The currencies of most countries will weaken as their trade deficits increase, but that does not hold for the U.S. for the simple reason that the world is on a de facto dollar standard. If anything, the economic turmoil in Argentine will strengthen the greenback. Japan has decided to depreciate the value of the yen to try and jump-start the economy. While there has been no decision by the European Central Bank (ECB), that organization is not straining to support the value of the Euro. Of course no one expects the Euro or the yen to plunge 40% in a week as the Argentine peso did. Unlike the dollar, though, currencies of other countries generally weaken when their trade balances decline. To the extent that a massive devaluation of the Argentine peso will reduce the trade surplus in Europe and Japan, those currencies will decline further, which is just another way of saying that the dollar will strengthen further. Production Worker Costs Relative To U.S. Costs