Dollar Weakness in the 1990"s

During the first six months of 1995, the U.S. dollar rebounded from 80 yen and 1.35 deutsche marks to approximately 100 yen and 1.42 D-marks. (Levy, 1995). Yet despite this recent rise, dollar weakness overall has accelerated during the past few years. Even so, many commentators and investors continue to believe that the outlook for the dollar is promising, or to put it more bluntly, that long positions in the dollar will eventually be rewarded (Los Angeles Times, October 6, 1994). Part of the reason for this optimism is the failure to grasp the real issues underlying the dollar weakness (See Table 1).

At the end of World War II, the dollar was considered the world's reserve currency. It was made convertible into gold at $35 to the ounce, and other currencies were made convertible to the dollar (if not right away, then eventually). At first, there were not enough dollars to go around, but by the mid-1950s, however, there was a great and growing surplus. The glut of dollars has persisted on and off to this day (Moffit, 1983).

In the 1960s, the U.S. dollar weakened dramatically as a flood of U.S. direct investment poured into Europe. In effect, the long-term capital outflows exceeded the sizeable U.S. trade surplus that then existed. By 1971, this imbalance had wrecked the Bretton-Woods system of fixed exchange rates. Once currencies began floating in the early 1970s, the dollar quickly sank due to a growing U.S. current-account defici

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evels and other world rates up with it. Short-and long-term rates peaking at 10 to 14 %, respectively, exceeded German rates by 4-5 percentage points. Today, U.S. monetary policy remains very loose, its short-term interest rates are, at best, flat in relation to other world rate levels. Though the Fed's modest rate hikes, in 1994 shook the over-leveraged financial markets, they were more symbolic rather than real acts of monetary tightening -- certainly very timid compared to the no-nonsense policies of the Federal Reserve under Volcker, in the 1980s. In fact, one expert has argued that U.S. real interest rates are inadequate to make U.S. investors change the structural diversification on which they have embarked, or to make foreign investors (already long on dollars) buy more (Magnus, 1994). The U.S. Federal Reserve would have to offer considerably in excess of that to re-activate capital flows that would help to push the dollar back up, at least in the medium term. This expert believes that the question is whether U.S. authorities would permit such monetary tightening and, if not, whether they may be forced into it by the extent of U.S. dollar depreciation in the future (Magnus, 1994). The Economist (Oct. 19, 1994)

Category: Economics - D