Weak-Dollar Medicine

Saturday's meeting of G7 finance ministers and Central Bank governors in Dubai concluded with a call for "more flexibility in exchange rates. based on market mechanisms." Big deal, right?

It's absolutely a big deal when the G7 finance leaders unanimously sign off on an ideal -- market-determined currency rates -- that will inevitably produce a weaker U.S. dollar.

Specifically, the G7 statement is a reprimand against Japan's practice of selling yen and buying dollars to hold down the value of its currency as a way to support cheap Japanese exports. In the wake of this announcement, Japan appears to have stepped back from its currency intervention, allowing the dollar to fall versus the yen and thereby other currencies as well.

A weakening dollar has a couple of positive benefits. For one, a weak dollar makes American-produced goods cheaper to foreign buyers, thereby fueling American exports and, significantly, American jobs to support those exports. In addition, to the extent that America's strong dollar has been responsible for a U.S.-centric world economy, a weaker dollar will help to restore a more balanced global demand profile by increasing the purchasing power of non-dollar currencies.

Be warned, however, that the weak-dollar prescription will likely come at a price. These implications are possible, if not inevitable:

1. A weaker dollar will buy less overseas, which means foreign goods will become more expensive to Americans. In other words, weak dollar policy is inflationary, making it a natural extension of Alan Greenspan's anti-deflation campaign. In turn, inflationary pressures will put upward pressure on interest rates as bond investors demand extra return for lost future purchasing power.

2. As the dollar slides, the U.S. will be a less attractive home to foreign investors because of the currency risk of holding depreciating dollars. Because of this currency risk, foreign investors will demand a higher rate of return, which will likewise create upward pressure on interest rates.

3. Because of the upward pressure on interest rates associated with (1) and (2), the stock market -- and especially stocks with rich valuations based on future growth -- could be vulnerable due to the depressing effect of higher interest rates on the present value of future profits. Higher interest rates would also stand to hurt the housing market.

Of course, the degree to which these weak-dollar consequences are manifested is entirely dependent on how far and how fast the dollar falls. And that's anyone's guess -- I haven't a clue.

A smooth and orderly descent in the dollar could result in a manageable reflation to the U.S. economy, along with greatly improved balance across the world's other economies. On the other hand, any sort of sharp fall in the value of the dollar or associated sharp increase in interest rates could cause some real problems. Let's hope for the former -- but I suggest being prepared for the latter.

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