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The Drifting Dollar

What the dollar's decline means and where it's heading next.

11:00 PM, Dec 4, 2006 • By IRWIN M. STELZER
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"YANKEE, STAY HOME" is what the world's currency markets are trying to tell us, as the dollar sinks to a level where it takes $2 to buy one British pound, and over $1.30 to buy a euro. And if you're thinking about a major purchase of a made-somewhere-other-than-the-U.S. product, think again. The flip side of that bad news is that America's exporters are cheering, while countries that have been counting on the United States to be the world's consumer of last resort are no longer so sure that they want us to cut our trade deficit. And Europeans with their newly powerful pounds and euros are finding that shopping here is so cheap that they can fly over, do their Christmas shopping in New York, and more than cover the cost of their airplane tickets.

The world has long urged America to get its trade deficit under control. Now might be the time. And the rest of the world is already wishing for the good old days of American profligacy. Economists are generally agreed that if the United States is to bring its trade deficit down from over 6.5 percent of GDP to a sustainable 2 percent, the dollar will have to fall by about 40 percent. That means that Britain's exporters--America is their biggest market--would find themselves trying to persuade Americans that the Jaguar that has been selling for, say, $80,000 is still a good buy at $133,000, and that a bottle of 18-year-old Macallan's Scotch that now retails in America for about $140 is worth sipping even at a price of $230. German exporters would also find life unpleasant. The $100,000 Mercedes would cost $166,000. Italy might find that American tourists willing to pay, say, $200 for a hotel room in Venice, would decide that $320 is so stiff that a vacation in Las Vegas, with its faux canals, will have to do. And the French, vocal critics of the U.S. trade deficit, are now calling for "collective vigilance" to stem the fall of the dollar, which is making it difficult for their winegrowers to peddle their wares in America.

Their pain, of course, is also ours. The days when the world sent us the output of their factories and we sent it a few pictures of our presidents may be no more. Still, since we are less dependent on imports than many countries are on their exports to us, our pain would be minor relative to theirs, which in some cases would be excruciating.

Few believe the dollar will hit such export-killing, import-spurring levels. At least not all of a sudden. To make a more realistic guess at the direction of the greenback, consider what has enabled it to stay so high, for so long, in spite of America's huge trade deficit:

First was the relative robustness of the American economy. While Europe wallowed in the consequences of its unreformed labor and product markets, America barreled ahead. Now the situation is reversed. The recent decline of the housing market, weaker sales of durable goods, and a downtick in consumer confidence, forced the White House to lower its forecast for 2007. Meanwhile, the German economy is showing flickering signs of life, and the United Kingdom continues to move ahead. So the direction of the divergence that enabled the dollar to remain relatively strong might--only might--be shifting. If the European Union grows more rapidly than the United States, investors will be attracted away from dollar-dominated assets and towards investments in Asia, Euroland, and Britain.

That trend is accelerated by investors' expectations concerning interest rates. The dollar was long buoyed by the Federal Reserve Board's upward ratcheting of interest rates, while Europe's central bankers by and large held the line. Now the situation might be reversed. A significant number of investors are ignoring Fed chairman Ben Bernanke's continuing concerns about inflation, and are expecting the weakening U.S. economy to force the Fed to lower interest rates in the spring, while the strength in Europe will force the European Central bank to follow the Bank of England and raise rates before this year is out. Such a reversal increases the relative attractiveness of non-dollar assets, and weakens the dollar.