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How hard will the dollar fall?
Fed Chairman says wide U.S. trade gap can be corrected in orderly way, but it's not a sure thing.
November 20, 2003: 2:01 PM EST
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - Though Federal Reserve Chairman Alan Greenspan said Thursday the huge U.S. trade deficit can shrink without crippling the dollar, and U.S. financial markets along with it, analysts warned a dollar plunge can't be ruled out.

In a speech in Washington, Greenspan said the U.S. current account deficit, the broadest measure of U.S. trade with the world, which has widened to about 5 percent of gross domestic product (GDP), can shrink without a sharp dollar correction.

"Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption," Greenspan said.

While a small drop in the dollar could be a good thing for U.S. exporters, making U.S. products more competitive overseas, too sharp a decline would slam stock and bond markets, raising interest rates and slowing the economy.

But Greenspan warned that gathering "clouds of emerging protectionism" -- referring, apparently, to measures such as the controversial steel tariffs imposed by Washington last year and Tuesday's tariffs on some Chinese textiles -- could hurt free trade, adding pressure to the dollar.

"The costs of any new such protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy," he said.

Most economists believe the dollar, which has fallen nearly 10 percent against the rest of the world's currencies since February 2002, according to Fed data, is due to fall further, since it gained about 35 percent between 1995 and 2002.

The U.S. economy imported $481 billion more than it exported in 2002, essentially borrowing more than $1.3 billion a day from overseas investors -- who were more than happy to lend the money, buying U.S. Treasury bonds and other dollar-denominated assets, because U.S. markets are considered the safest and most stable in the world.

But the deficit has gotten even further out of whack this year, leading many economists to warn that a dollar drop is inevitable.

"Without a further [dollar] decline, U.S. net foreign indebtedness and the federal debt burden threaten to become overwhelming," Goldman Sachs economists Bill Dudley and Jim O'Neill wrote in a research note last week.

Hard or soft landing?

The only question is what kind of decline that will be. Will the dollar go quietly, or will it get roughed up along the way?

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The United States has run enormous current account deficits before without causing much trouble. In the 1980s, the dollar was supported by high interest rates, which lured overseas buyers to Treasury bonds. In the late 1990s, overseas capital poured into U.S. markets to buy into the tech-bubble boom, keeping the dollar afloat.

But things are different this time, with rock-bottom U.S. interest rates making the country less attractive to investors from abroad, while those same investors are growing more worried about Washington's approach to foreign relations and trade. All that adds up to a bitter cocktail that could turn off foreign investors, raising the risk that things could get ugly.

"Markets become disorderly due to aggregate psychology. That's difficult for anyone to assess at any time, but you look for red flags, like significant overreactions to data," said David Gilmore, currency analyst at Foreign Exchange Analytics in Connecticut.

Tuesday's sharp dollar decline, which hurt U.S. stock prices, was an example of just such an overreaction, Gilmore said. The "fairly minor news" that the United States was imposing quotas on a small number of Chinese textiles was met by much gnashing of teeth in the currency market, evidence, Gilmore said, of a "very nervous market."

A Treasury Department report Tuesday showing a sharp drop in overseas purchases of U.S. stocks and bonds in September was even scarier, highlighting economists' fears that, if foreign investors lose their appetite for U.S. assets, the dollar's decline could be hard and fast.

"What I call a dollar crisis is when you have a big, negative feedback loop, with international investors spooked purely because of the currency, shedding U.S. assets, which would be more dollar negative, and it would just feed on itself," said former Fed economist Lara Rhame, now a senior economist with Brown Brothers Harriman.

"That's the nightmare that keeps a lot of investors up at night -- but I just don't think that scenario is realistic."

Central banks help -- and hurt

For now, other nations' central banks, which have too much to lose in a sudden dollar plunge, are doing everything they can to prop up the dollar.

Alan Greenspan
International Trade
Economic Indicators

The Bank of Japan, for example, has been spending yen to buy dollars in a bid to keep its currency weak versus the dollar and boost its struggling economy. On Wednesday alone, analysts said, the BOJ spent $9 billion or more to help buoy the dollar.

But Greenspan, in his speech Thursday, also warned that overseas governments could seek to rebalance their portfolios if they felt they were carrying too many dollar-denominated assets. Already, dollars make up 65 percent of foreign central bank reserves, Greenspan said. How much more can they take on before they want to diversify?

Goldman Sachs economists Dudley and O'Neill warned that Asian central banks may only be delaying the inevitable, raising the chances that the eventual decline will be harder than necessary.

Greenspan said that when the dollar drops, history shows it will probably be an orderly decline, and he said the flexibility of international markets should also help the dollar avoid a painful correction.

On the other hand, other economists, such as the late MIT professor Rudi Dornbusch, have noted that current account corrections in smaller economies are usually ugly. And several international organizations, including the International Monetary Fund and the European Central Bank, have warned that the risks of a scary decline in the dollar are higher than ever.

"It's rare to have a major current account dislocation in the United States," said Gilmore of Foreign Exchange Analytics, "but it can happen."  Top of page

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