Why the Collapse of the Dollar Is Just a Myth By Allan H. Meltzer

Statements by European politicians and many others leave the impression that the dollar has "collapsed" against the euro and remains on the steep end of a roller-coaster ride heading south. Gerhard Schroder, the German chancellor, has hinted several times that the European Central Bank has been negligent, stubborn, or worse for not reducing interest rates to stop the euro's appreciation. This excitement was all based on a 5 to 10 percent appreciation of the euro above its price at launch in 1999. Of course, Mr Schroder prefers to take as his starting point the temporary floor reached two years ago, so he can claim the euro has appreciated as much as 50 percent against the dollar. That is true, but very misleading--like using the coldest day in January to dictate the clothing that you wear every day. The chancellor would be wise to take a longer-term perspective. I converted monthly average D-Mark/dollar exchange rates before the launch of the single European currency into euros at the official conversion rate of DM 1.95583 to the euro. The resulting series shows fluctuations around a monthly average value of Euros 0.83 per dollar from January 1990 to December 1998. This January and February the value was Euros 0.79 to the dollar, the equivalent of DM 1.55. This value is Euros 0.04 lower than the average exchange rate during the 1990s--and the euro has since declined. Current values are well within the range experienced in the 1990s--Euros 0.71 to Euros 0.94. The big change came with the appreciation of the dollar against all currencies that began in about 1999. By October 2000, euro holders had to pay Euros 1.17 per dollar. Between 1999 and 2002, the monthly average exchange rate was Euros 1.05, a 22 percent appreciation of the dollar from its average value in the 1990s. The dollar was overvalued, as the flood of imports and the big increase in the U.S. trade deficit suggest. The dollar has not collapsed against the euro, or any other currency. It has returned to the range it was in before 1999. I cannot recall either Mr Schroder or any other prominent eurozone politician complaining about the dollar/D-Mark exchange rate when it was at its current rate in the 1990s. The big change is not so much an appreciation of the euro as a reduction in the overvaluation of the dollar following the financial crises of the late 1990s. Other factors include replacement of the growing surplus in the U.S. budget by a large deficit. Differences in interest rates and expected inflation rates may also have contributed. Dollar assets were a safe haven in the late 1990s for foreigners who bought bonds, and seemed an attractive investment for those who bought equities to own a share of the new economy. When the dollar floated up to a peak early in 2002, Mr Schroder did not propose that the ECB should tighten policy to help the euro appreciate. Mercantilism lives on and is certainly not confined to Germany. In truth, the ECB may choose to lower its interest rate, but it has no more reason to ease policy now to manage its exchange rate than it did in the mid-1990s. What about the future? The U.S. presses China and Japan to stop buying its bills and bonds and to let their currencies float freely. Freely floating rates are desirable for many countries that have financial systems strong enough to absorb the fluctuations in asset values that accompany exchange rate changes. That certainly does not describe China or Japan. Japan's policy has at last allowed monetary expansion to support economic expansion and reduce deflation. The correct policy for Japan is to continue its long-delayed effort to end deflation. The correct policy for China is to prevent an increase in inflation. The correct policy for the U.S. is to let other countries decide on their preferred policy. The dollar has fallen, but it has not collapsed. Now that it is back in its former range, there are lots of willing buyers for its debt. If the U.S. continues to report some of the fastest productivity growth rates in its history, and profit rates remain high, there should be no shortage of buyers of U.S. assets and equities. The strong response to last Friday's U.S. jobs report also shows that the dollar remains attractive. Predicting exchange rates is no better than flipping a coin. It is hazardous to believe such forecasts or to act on them. That goes for governments and central banks that want to second-guess or "correct" the market's judgment. It also goes for those who predict the dollar will collapse. Allan H. Meltzer is visiting scholar at the American Enterprise Institute.

AEI Print Index No. 16574