Friday, October 22, 2004

The US dollar is overvalued. That's the verdict rendered by the evidence of the US current account deficit, which promises to top $600bn this year, and the repeated efforts of the Bank of Japan to prop the thing up when it begins to fall. I did a little number over at The American Street yesterday talking about the 25% decline in the value of the dollar vis-a-vis other major currencies since early 2002.

Today the New York Times takes up the matter, urging both Bush and Kerry on to a repeat of the deal Ronald Reagan and the G7 orchestrated in the mid-1980s to bring down to high-flying dollar.
If Mr. Bush gains a second term, he need only recall what his role model, Ronald Reagan, did. After cutting taxes in the first term and seeing the trade deficit rise to previously unimaginable levels, he engineered the Plaza accord in the first year of his second term. The dollar fell and the trade deficit gradually narrowed. It is time to consider such a policy again. And whoever is elected may want to get that process started sooner rather than later.
OK, anyone who thinks Bush is anywhere near as reasonable as Reagan and will even broach the subject of tax increases is clearly living in fantasy land. But that's not the point. The point is that the Plaza Accord brought down a seriously overvalued dollar, and it would be nice to see such a thing take place today.

Matters are quite different today, however. In the 1980s the dollar (measured by the nominal major currencies index) peaked in March 1985 at 143.90, and the current account deficit peaked at 3.45% of GDP in the fourth quarter of 1986. Today the dollar (by the same index) is at 85.33 and the current account deficit at 5.7% of GDP (2004:II) and rising.

The upshot is that the USD was far far stronger in the 1980s than it is today, and that it has a lot further to fall today than 20 years ago.

For example, at its 1980s peak the undervalued British pound bought a mere $1.05. Today the undervalued pound buys $1.83. The overvalued dollar bought �262 in February 1985. Today the overvalued dollar buys only �107. Back in the day, one overvalued dollar could get you 3.45 Deutsche mark; now you can pull in just �0.80 -- or 1.56 DM.

As measured by the major currencies index, the post-1973 low point for the dollar was April 1995 when it bottomed out at 80.33. In an historical perspective, this is the definition of a "weak" dollar. By the same index, on Thursday the dollar stood 83.61. The "strong" dollar of today is a mere 4% higher than the weakest weak dollar of the post-Bretton Woods era.

If the USD needs to fall some 20% to bring the current account deficit under control -- as Michael Mussa among others believes -- then we're looking at a future with the weakest dollar in post-WWII history. Forget the looming catastrophes of the colonial project in Iraq. How in the world is the United States going to act as global hegemon riding the weakest currency in three generations?


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