A quote from Dashiell Hammett's novel "Red Harvest" offers a good preamble to any economics story, but especially one about the dollar.
"I don't want to brag about how dumb I am," says a young detective, "but this job is plain as astronomy to me. I understand everything about it except what you have done and why, and what you're trying to do and how."
It's a good bet that most people find the "dollar problem" equally perplexing. If they travel abroad, they know that a declining dollar makes things more expensive: the dollar buys less foreign currency. Likewise, it's understood that a dropping dollar raises import prices here, contributing to inflation. Otherwise, the dollar remains a mystery.
It shouldn't. Once you recall that the dollar is the more common form of international money - used to conduct a large part of the world's trade - much of the rest becomes clear. Countries hold 80 percent of their foreign currency reserves in dollars. Multinational firms and individuals keep spare funds in dollars. A drop in the currency erodes this wealth and has the same effect abroad as inflation does at home: it shakes people's confidence.
But most of the world has a love-hate relationship with the dollar. They want the dollar to retain its key position in the international money system, but they despite the special status this confers on the United States. They want the dollar to be "strong," but they fear the stiff trade competition from the United States that a strong dollar requires.
Oil constitutes the most dramatic illustration of the special status that the dollar confers and the contradictions it inspires. Oil is paid for in dollars. When world oil prices quintupled in 1973 and 1974, most countries had to scramble to find the needed dollars. Either they had to reduce other imports or borror overseas. This limited their economic freedom and increased the incentive to conserve fuel.
By contrast, the United States simply purchases oil with its own currency. There's been little inducement to conserve.
That other countries resent this is no surprise. But they do not resent it sufficiently to want the United States to suffer the consequences: a sharp decline in the dollar's value. Ordinarily, such a more dollar abroad - last year's U.S. trade deficit was $31 billion - than foreigners wanted to hold. More dollars would be offered for sale on foreign exchange markets than demands at existing rates. So the dollar's price would decline.
In fact, that has happened, but only after the central banks of Germany, Japan and Britain made Herculean efforts to prevent it. In the past six months, these three countries probably spent more than $20 billion of their own currencies to buy excess dollars. Their motives are no secret. The United States remains the world's largest export market (absorbing about 15 percent of all exports) and, as the world's largest exporting country. [TEXT OMITTED FROM SOURCE] potentially the most dangerous competitor. No other trading country relishes the prospects of its exports being jeopardized by a cheaper dollar.
Consequently, the dollar's special position - and other countries' ambivalence about it - has delayed some of the adjustments required by the changing economic realities of the 1970s. Not only has the United States been spared the full blast of higher oil prices, but until recently, Germany and Japan continued to harbor the illusion that they could count on a rapid growth in exports to sustain rapid growth at home.
In part, these illusions stemmed from the relatively high value of the dollar in late 1976 and early 1977. This high value made U.S. exports less competitive and the American market more attractive. Since early 1977, the dollar has declined about 20 percent against the German mark and about 30 percent against the yen.
No one can easily explain why the dollar should have been so "overvalued" as recently as a year ago, except to note that massive pools of dollars abroad - called Eurodollars - heavily influence the determination of exchange rates. These funds are in relatively "liquid" form: that is, bank deposits and securities that can be easily sold for other currencies.
Switches in and out of different currencies based on "expectations" - meaning anything from fears of political instability to inflation - have made the system of "floating" exchange rates far less stable than anyone anticipated. Under a floating system, rates are determined primarily by supply and demand for different currencies. Under the system of "fixed" rates, which collapsed in August 1971, countries had to maintain specified rates by intervening in exchange markets.
The following table indicates the value of the dollar (100-1969) against a "basket" of currencies of the 10 leading industrial countries. The percentages in parentheses indicate the change from the previous level:
Aug. 1971 96.8
July 1973 77.1 (-20.4%)
Jan. 1974 88.7 (+15.0%)
Jan. 1975 80.4 (-9.4%)
Jan. 1976 86.6 (+7.7%)
Jan. 1977 90.4 (+4.4%)
Sept. 1977 89.5 (-1.0%)
April 1978 82.4 (-7.9%)
Explaining the sharpness of these fluctuations, however, is difficult. The dollar's rise in late 1974 may have reflected the fact that the United States was less vulnerable to oil scarcities than other economies. Dollars seemed attractive. Now, rising doubts about America's ability to control inflation and oil imports have coincided with a lessening of fears of political instability in Europe. The dollar seems less attractive.
But who knows? In the last week, the dollar has staged a slight recovery, and it may now be "undervalued" just as it was "overvalued" in early 1977. Believing this so many experts - including former Federal Reserve Board chairman Arthur F. Burns - continued to advocate an active policy of controlling currency prices.
Such advice ought to be resisted. The size of the Eurodollar pool is roughly put at between $300 billion and $500 billion. Even a small shift of these funds can overwhelm official intervention.
More fundamentally, exchange rate fluctuations reflect the uncertainties of an uncertain age. Trying to quell those uncertainties by tinkering with the markets is like trying to cure pneumonia with mouthwash.