Like a ticking time bomb, the falling dollar has grabbed the attention of Japan and West Germany, forcing them to consider adopting economic policies the United States advocates. Treasury Secretary James Baker III and Japanese Finance Minister Kiichi Miyazawa met yesterday in Washington and were expected to reach an understanding on how Japan can stimulate its economy so as to reduce the US trade deficit.
Japan and West Germany stand to lose the most export power with the dollar's decline. They are verging on recession. Share prices in Frankfurt plummeted earlier this week. Bonn and Tokyo are considering interest-rate cuts to boost their domestic economies, hence imports.
``Improving US competitiveness means a decline in another's competitiveness,'' says John Abbink, a specialist on European companies for Merrill Lynch in New York. (``Competitiveness'' latest congressional watchword. Story, Page 7.)
If all goes as US policymakers hope, however, the lower dollar - which has been falling since early 1985 - should begin to make the US trade picture look better in the next few months. This is because American goods will be cheaper than those from Japan, Germany, and some other nations. Cries for trade protection should abate.
At least, that's the theory.
But so far the falling-dollar, improving-trade scenario has not worked. Some economists chalk this up to time lags. William Cline, senior fellow at the Institute for International Economics in Washington, D.C., says it takes two years for an adjustment in exchange rates to begin improving a trade balance.
So if the dollar reached its highest level against the yen and other key currencies in the first quarter of 1985, the largest trade deficit will be tallied by the first quarter of this year - and ``you would expect it to come down after that,'' Dr. Cline says.
The trade deficit was at an all-time high of $170 billion for 1986 (Japan, by contrast, had an $82 billion trade surplus). Most economists reckon that by the end of 1988 the US deficit might be down to $100 billion. Even if that is overly optimistic, Cline says, the trend would be encouraging, and ``that outcome could prevent massive protectionism.''
But Americans should not expect this dollar devaluation to work exactly like the devaluation in the 1970s, says economist David Hale of Kemper Financial Services in Chicago. One big difference between now and then, he says, is that capital goods are virtually the only competitive advantage US manufacturers enjoy - and slow growth worldwide has lessened demand for these goods.
US consumer goods have been largely blown away by items produced in Japan and East Asian nations. Dr. Hale notes, ``If the dollar reached parity with the yen, then you might see us making dolls again in South Carolina, but that is unlikely to happen.''
Is there a connection between the falling dollar and the rising stock market?
There are several links, but they are not guaranteed to work at all times. First, the cheaper dollar makes it cheaper for many overseas investors to snap up US stocks. That prompts heavy buying from abroad - especially from Japan.
Also, if the trade picture is improving, US companies will eventually be more competitive. Consequently, many investors are buying shares of export-oriented US companies in expectation of better profits in the next year or so. But that is a rather faddish thing to do; if corporate earnings are disappointing in the next few quarters, the buying spree might vanish.
Finally, if a sagging dollar leads to a rise in interest rates, the stock market rally could stall. Other countries and other stock markets are doing well right now for a variety of reasons, some of them dollar related.
Hong Kong, Singapore, South Korea, and Taiwan benefit greatly as the strong yen makes Japanese companies less competitive. In London, investors expect rising oil prices to benefit the British economy. Higher gold prices (a consequence of the falling dollar) have helped the Canadian stock market. Stronger commodity prices have given Australia a boost.
Interestingly, the Tokyo stock market has been booming, too. Mr. Abbink points out that the Japanese economy is huge, and domestically oriented companies will benefit from any government efforts to stimulate conditions. Japanese companies have also built up huge surpluses from the heyday of exporting; these surpluses must be invested. Also, the Nikkei index, which measures the Tokyo stock market, is also calculated in an odd way that gives it an upward bias.
Could the falling dollar get out of hand?
If the dollar goes too far, investors might lose confidence in US government bonds. The money to finance the federal budget and trade deficits could migrate elsewhere. Inflation could flare up, too, since Japanese and German manufacturers will eventually pass along price increases - and US companies might follow suit to increase profit margins.
The Federal Reserve then might need to step in and stabilize the dollar by raising interest rates. And higher interest rates could cause the US economy to slow down and end the Wall Street rally. Concerned about these side effects, Federal Reserve chairman Paul Volcker has said the dollar has fallen far enough.
It is probably near equilibrium, although this depends on when the US trade deficit turns around or on whether investors defect from US Treasury bonds.
``It requires a good deal of political patience on the part of Congress,'' says Cline. ``And there must be an expectation of patience on the part of private investors. The chances are relatively good that we will avoid an investor break or panic.''