A very simple lesson emerges from the dollar's recent distress: We are no longer the sole masters of our own ship. Ever since the end of World War II, the United States has run its economy as if the rest of the world didn't exist. We simply assumed that what was good for us was good for them. If they didn't agree, let them stew.
Well, that formula no longer works. Since 1975, the United States has expanded its economy more rapidly than most of the world. We also have paid less attention to inflation than other countries have. Right or wrong, our priorities didn't match their priorities.
The upshot now, however, is that we are bending - or rather being bent - toward their priorities. Slower growth impends, as do higher interest rates. It will be tougher to lower unemployment, which stood at 6.2 percent in July. But these steps could improve the dollar's position by diminishing demand for imports (slower growth) and making it more attractive for foreigners to hold dollars (higher interest rates).
That we now may be forced into this stance is a reminder - if, after the rise in oil imports, one is needed - that actions abroad weigh heavily on the U.S. economy. We have learned that a big dollar depreciation aggravates inflation. Not only do import prices rise, but U.S. firms competint with imports also raise their prices.
In-all, a 10 percent drop in the dollar's value amy add one or two percentage points to prices over a year or two. Interestingly, the dollar's value has dropped roughly 15 percent against a basket of 10 foreign currencies in the past year.
Moreover, we have been reminded of the dollar's symbolic importance. Foreigners take it as a crude barometer of America's economic strength and stability. Letting it slide undermines America's but undeniable way.
To attribute today's uncertain outlook - which includes the possibility of recession - exclusively to the dollar would be to oversimplify. It also reflects rising domestic pressures to stem the quickening rate of inflation. But the shaky dollar contributes to this uncertainty and indicates that the United States is growing more like other major economies.
For the others always have faced balance of payments problems and potential currency weaknesses. Unlike the United States, most of them couldn't conduct trade in their own currencies, but needed to earn foreign exchange - "strong" currencies, such as the dollar - to pay for imports. When foreign exchange reserves declined, countries had to retrench.
The United States escaped this discipline because the dollar was - and is - the main form of international money. In the 1960s, when foreigners became restless with their dollar holdings, we evaded, the resulting pressures simply by changing the rules of the international money game.
If people wanted to trade too many dollars for our gold which represented "backing for the dollar), we simply stopped trading. That happened in 1968, when we halted unlimited gold sales on the free market, and again in 1971, when we barred foreign governments from trading dollars for American gold.
By 1971, we also realized that the dollar no longer could be held in a fixed relationship to other currencies. In that era of fixed exchange rates, one dollar equalled 360 Japanese yen and four German marks.
So we forced a "floating" system of exchange rates on the rest of the world. Under the floating system, supply and demand determine exchange rates. We assumed that the dollar's depreciation would correct our balance of payments problem by making imports more expensive and exports cheaper. Today, a dollar roughly equals 190 yen and two marks.
All these changes were aimed at preserving maximum freedom to manager our own economy. But now we are beginning to recognize three further changes that severely limit this freedom.
First, unlike most of the postwar era, the United States is no longer a low-inflation country. A recent analysis in the monthly newsletter of the Morgan Guaranty Trust Co. makes this clear. Until 1970, the United States consistently enjoyed one of the world's lowest inflation rates. Between 1951 and 1970, for example, the U.S. inflation rate averaged only 2.4 percent, slightly above Germany's rate (2.2 percent) and lower than any other industrialized nation.
The United States has lost this enviable position. For the year ending in June, U.S. consumer prices rose 7.5 percent, which was the 10th highest rate among 20 industrialized countries. By contrast, German prices increased only 2.7 percent, Japanese prices 3.6 percent and Belgian prices 3.7 percent. Higher inflation naturally contributes to dollar depreciation; export prices rise, creating pressures to offset the increase by a decline in the currency.
Second, the United States has lost its once huge technological edge. In the 1960s, this superiority resulted in large trade surpluses, which counterbalanced the outflow of funds for foreign investment, military spending and foreign aid. But in most areas, European and Japanese firms now offer competitive or superior products. As much as on imports, this decline explains last year's $31 billion U.S. trade deficit.
Finally, there is the emergence of the Eurodollar market. This much-misunderstood phenomenon represents a pool of dollars deposited abroad and variously estimated at $300 billion to $400 billion. Its existence effectively prevents governments from controling exchange rates. There is simply too much money able to shift among currencies, nullifying government sales or purchases of currencies. Again, that represents a change from the 1960s.
Collectively, these changes have deprived the United States of any quick, clever way to control the dollar's value. In time, the dollar's recent steep decline will tend to be self-correcting as Americans find it more expensive to travel abroad, imports become more costly and exports become cheaper. But, if inflation worsens and our relative technological position continues to slide, so will the dollar's value.
We are slowly witnessing the end of the era of dollar supremacy. For the United States, it was a comfortable era, and its replacement will be much less so.