WE WERE TAUGHT in graduate economics classes that if a country runs large and persistent trade deficits, the value of its currency will decline relative to the value of the currencies of its trading partners. Oh yes, other things being equal, of course. Then we entered the real world and found that other things are never equal.

Which may be why the dollar continued to levitate as America's trade deficit chalked up one record after another. We bought the world's goods--cars, sneakers, apparel--and in return sent out bits of paper with the pictures of American presidents printed on them. As the dollars flowed in increasing amounts to foreigners, economists waited in vain for the value of those dollars to drop, so that American goods would become cheaper overseas, and foreign goods more expensive here. That, they reasoned, would correct the trade imbalance.

But two things happened to prevent such a natural correction. First, Japan and China decided that their export-led economies can only grow by keeping their goods cheap in the United States. So the Chinese, formally, and the Japanese, less formally and less rigidly, tied the value of their currencies to the dollar to prevent them from appreciating.

Second, the world's investors continued their love affair with U.S. assets, and used their accumulating pile of dollars to buy American companies, shares, properties, and the government bonds being churned out by the Treasury to finance the mounting U.S. budget deficit.

NOT CONTENT to leave this situation alone, the Bush administration began to make noises about the overly strong dollar, and the need for its trading partners to let the value of their currencies rise. The White House also instituted protectionist measures to demonstrate its desire to reduce the imports that opposition politicians claim are destroying American jobs.

Simultaneously, the monetary policy gurus at the Federal Reserve Board announced that despite the accelerating recovery of the U.S. economy--growth at over 8 percent, productivity at the highest level in over 20 years, construction spending setting new records, the manufacturing sector expanding as new orders soar, consumer confidence rising--they would not raise interest rates for "a considerable period." This led foreign investors, always sensitive to signs of impending inflation, to wonder whether the dollars they were investing in America would depreciate in value, and whether the interest they might earn on those investments would fail to rise to compensate for renewed inflation.

SO THEY MORE OR LESS stopped investing in America. Capital inflows into the United States fell in September to one-tenth of the level of the previous month. As BusinessWeek put it, "The greenback's decline could turn into a rout. . . . Foreign investors are rebalancing their portfolios away from U.S. securities." That reduces the demand for dollars, and therefore their price.

Since China and Japan are intervening in currency markets to prevent the dollar from getting dearer in terms of their own currencies, the brunt of the readjustment is falling on the euro and sterling. And a heavy brunt it is. The euro is now above $1.20, a record, and the pound is above $1.70. That has made goods manufactured in Europe and Great Britain more expensive in America and, in the case of the eurozone, where domestic demand is weak, threatens to turn no-growth into slump.

So much for a brief history of how we have arrived at a dollar that is sinking, and will probably continue to do so. The important question is: So what?

FOR ONE THING, with imported goods more expensive, the competitive pressure on American manufacturers is reduced, permitting them to raise prices after a long period in which they had lost pricing power. For another, in order to attract foreign investment, interest rates will have to go up to make American assets more attractive--another way of saying that bond prices will have to fall. As Martin and Kathleen Feldstein, he a former chairman of the president's Council of Economic Advisers, pointed out several years ago, "If--or when--foreigners decide that they don't want to lend so much to the United States, the dollar will decline, interest rates will rise, and inflation will increase." Bad news for bond holders, but good news for investment banks as their clients rush to borrow before interest rates go up.

That's not all. Oil prices have remained above the top of the OPEC cartel's target range of $28 per barrel. But producing nations are finding that they can buy less with their dollars. Whereas the Saudis would once have had to sell about 5,000 barrels of oil at the top of the cartel's price range in order to earn enough dollars to pay for a brief, £100,000 visit to their favorite haunt, London's Dorchester hotel, they now have to sell about 6,000 barrels at that same price to pay for enough sterling to cover the cost of their stay. So, they have in effect abandoned their $28 ceiling, and are keeping production low enough to support prices in excess of $30 to offset the reduced purchasing power of their dollars.

Bush asked for restraint. But Saudi oil minister Ali Naimi isn't restraint minded. So he used last week's OPEC meeting to announce, "The dollar is weakening, and purchasing power is quite weak, so [the current high price] is okay." After all, Naimi wouldn't want to risk his job, and possibly his neck, by allowing the living standards of the 5,000-7,000 Saudi princes to decline. Bad news for American consumers.

Still, the negative economic consequences of a continued fall in the dollar are unlikely to overwhelm the forces that are driving the U.S. economy forward. And if the decline does not become the "rout" that some are predicting, it should begin the healthy process of whittling away America's trade deficit.

Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.

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