Date created:7 May 2001
Last modified: 7 May 2001
Maintained by: John Quiggin
John Quiggin

US dollar needs a pasting

Australian Financial Review

29 March 2001

In January 2000, at the peak of the Internet stock mania in the United States, I observed 'It is difficult to see how an economy in which investment decisions are based on numbers like these can avoid some sort of financial catastrophe'. Since then, the most absurd numbers, such as the multibillion dollar valuations of profitless etailers such as pets.com and Etoys.com, have been replaced by more realistic valuations (zero, in both cases). The NASDAQ index has fallen from its peak of 5000 to less than 2000. The Dow-Jones index and the broader Standard & Poor's 500 index have fallen by about 20 per cent from their peaks.

Although a recession is almost certainly under way in the US, the deflation of the stockmarket bubble could not, so far, be described as catastrophic. A two-quarter recession, or even a year of zero growth, would represent a very soft landing from the massive boom of the 1990s. If the US begins to recover later this year, as is generally predicted, its status as the world's leading economy will barely have been dented.

There are however, a number of reasons for doubting that such a recovery will eventuate. The most important is an event which attracted a good deal of attention in Australia - the rise of the $US to a value above two Australian dollars, with a corresponding appreciation against the euro and the yen. To the extent that this event was noticed at all in the United States, it was seen as a market vote of confidence in the long-term prospects of the US. It was also a victory for the strong dollar policy inherited from the Clinton administration, and supported by Bush and Greenspan alike.

Other events of the last few weeks, however, cast doubt on whether the strength of the $US is really such good news for the economy. First, stock markets have fallen across the board. Second, consumer spending in February fell sharply, surprising most economists. Third, and surprising nobody who was paying attention, the US current account deficit hit an all-time record in 2000.

Taking the first two points together, it is clear that the growth in consumer demand that has driven the US economy in recent years cannot, and should not, be sustained. As the spurious capital gains generated by the stock market bubble evaporate, the need for households to build up their savings will become more and more evident. It is also evident that much of the massive investment of the last few years, particularly in telecommunications and Internet businesses, has been wasted. A sharp downturn in investment is already evident, and, when growth resumes, investment is unlikely to match the pace of the late 1990s.

Finally, State and Federal governments have been beneficiaries of the stock market boom. The projected $5.6 trillion Federal surplus will be a lot smaller wihtout income from taxes on capital gains and stock options. If the remainder of the surplus is allocated to tax cuts in the second half of this decade, as is currently proposed, there will be precious little new government spending in the short term. Indeed, the Bush administration is currently calling for draconian cuts in public expenditure.

But if consumer demand, investment and government spending are all depressed, how can the economy recover? The standard answer for an economy in this situation, particularly one with a large current account deficit, is that it must seek an export-led recovery.

Given the chronic depression of the Japanese economy, and the fragility of the recovery in the rest of Asia, an export-led recovery will be a difficult trick to pull off. But a difficult trick becomes an impossibility while the dollar remains massively overvalued. In the absence of a substantial depreciation (about 40 per cent), exports, and therefore the US economy, have no prospect of recovery.

The reason for the consensus behind the strong dollar policy was that a strong dollar helps to keep inflation down. A currency depreciation raises the prices of imports and may trigger a wider inflation.

In current circumstances, however, the possibility of renewed inflation is the least of the dangers facing the economy. The best thing Alan Greenspan and George Bush could do, for the US and the world as a whole, is to start talking down the US dollar.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.

Read more articles from John Quiggin's home page

Go to John Quiggin's Weblog