A year ago this month, Federal Reserve Governor Lyle E. Gramley told a business group in Minneapolis that "a significant decline in the value of the dollar in exchange markets is widely forecast.
"Such a decline is clearly essential to restoration of international competitiveness to U.S. industry, and in that sense it would be welcome. But when it occurs, it will have two effects that will be most unwelcome -- namely, it will add to our inflation rate, and it will put upward pressure on our interest rates."
Those were hardly controversial predictions. At the time, they represented conventional wisdom, and to many economists they still do.
But the conventional wisdom may no longer be relevant to the value of the dollar against foreign currencies, because the demand of foreign investors for dollars and dollar-denominated securities continues to balloon.
The dollar's value has leveled off and has been fluctuating widely in a volatile market; but there is no sign that the foreign investors whose demands drove the dollar to record highs this past spring are becoming disenchanted.
When the Treasury Department sold five-year notes to raise cash late last month, domestic investors bought $7 billion worth at an average yield of 9.95 percent. In a separate issue for foreign investors the same day, overseas buyers took $1 billion worth at an equivalent average yield of 9.76 percent.
Even at the lower return, the foreign issue was oversubscribed -- proving once again, Treasury officials said afterward, that foreign investors are willing, even determined, to invest in dollar-denominated securities, to own dollars, and to increase their dollar portfolios even when interest rates are declining.
"There's no dollar bubble that's going to burst," one senior Treasury official said. "The dollar is too important to too many people."
If he is right -- and most economists, policy analysts and currency traders seem to agree with him -- it means some bad news and some good news for the U.S. economy.
It means that the dollar is likely to retain much of the strength against foreign currencies that lifted it to all-time highs earlier this year and undercut U.S. trade competitiveness.
It also means that the foreign capital on which this nation is increasingly dependent to finance growing budget and trade deficits will continue to flow in because of the sustained attractiveness of this economic environment to foreign investors.
As it was a century ago in an era of vast industrial expansion, the United States is a net importer of capital. In 1984, according to Treasury figures, foreign investors bought $11.88 billion worth of U.S. corporate bonds, up from $918 million the year before, and $21.4 billion worth of Treasury debt, up from $5.4 billion in 1983. These figures do not include billions of dollars in foreign investment in corporations, real estate and other nonliquid U.S. assets.
The impact that the high dollar and the foreign investment it attracts has on the economy has become one of the nation's central economic issues.
Executives of basic industries such as steel, heavy machinery and textiles say their competitiveness is steadily being eroded because a high dollar makes rival imports relatively cheaper and cripples the ability of U.S. firms to sell abroad. As the trade deficits have escalated in the past year, these executives have found advocates in some high-tech industries.
Other observers -- many of whom say there really are no experts in this volatile, global market that often is swayed by psychological factors -- argue that, on balance, foreign investment is good for the country, as a means of fueling industrial expansion and holding down interest rates by increasing the supply of capital.
"Most Americans have benefited through lower inflation" as the dollar has risen, said David C. Mulford, assistant Treasury secretary for international affairs. It is "painful" for some industries and workers, he said, but "when this is over, we will have a more modern industrial economy" because U.S. industries will have to become more efficient to survive.
"Your head will spin at the speed of reindustrialization in this country," Mulford said, but "it may be in different industries" from those squeezed by the high value of the dollar.
Mulford said in an interview that for the dollar to decline significantly against foreign currencies, "people have to be disillusioned about our economic performance and more upbeat about the performance in other countries." Otherwise, he said, the only foreign holdings likely to move swiftly out of dollars are in the "layer of hot money, the overnight money, that probably helps explain the short-term volatility of the exchange markets. It doesn't affect the long-term trend."
There is no possibility, he said, of large-scale Treasury intervention to bring down the value of the dollar. Intervention, he said, "doesn't work."
Economists, traders and policy analysts say they expect some leveling out of exchange rate imbalances as economies improve in Europe and Latin America. They agree that a moderate downward adjustment in the value of the dollar over the rest of this year is probable and desirable, but not everyone thinks it's inevitable.
"The real problem is, what if the dollar keeps going up?" a Federal Reserve analyst asked recently. "If key investors want to hold the dollar come hell or high water, the world will have to accommodate to that."
"The possibility of a downshift in market expectations cannot be ruled out," said Morgan Guarantyfor The Conference Board Trust in a recent World Financial Markets newsletter, "but neither can a fresh surge in the dollar be precluded. . . . "
Even if the dollar turns downward, however, analysts agree with Mulford that the odds are heavily against a sudden bailout on the dollar that would lead to a sharp break in the currency's value. They offer a long list of reasons why abandonment of the dollar and a drastic drop in the dollar's exchange rate are unlikely:
* The sluggish economies of other industrialized nations are restraining the relative demand for investment capital there, and financial institutions are reluctant to make major investments in debt-plagued Third World countries. These factors combine to enlarge the pool of funds available for investment in the United States.
* There is no sign of a move out of dollars into traditional hedges against inflation such as gold or real estate. In fact, as the Morgan Guaranty newsletter said, "worldwide disinflation is shifting portfolio preferences away from such inflation hedges as precious metals and land toward financial assets, boosting demand for dollar assets."
* The foreign investor profile is changing in ways that strengthen the dollar. While the cash-strapped OPEC countries have been liquidating their dollar-denominated securities, Japanese and other East Asian investors have greatly expanded their holdings of U.S. public and corporate debt. Japanese investors, for example, added $6.1 billion to their portfolio of Treasury paper in 1984. Analysts say these Asian countries are strongly attached to the dollar -- politically and psychologically as well as economically -- and are unlikely to abandon the dollar for political reasons.
* Foreigners are developing a vested interest in keeping the value of the dollar high, and not just for trade reasons.
David Hale, chief economist of Kemper Financial Services in Chicago, has pointed out that "at the current rate of borrowing, the U.S. will have an external debt of one trillion dollars by the early 1990s" -- a fact that he and other analysts see as giving foreigners an incentive to make sure they are repaid in dollars that have retained their value.
* Trading on the 90-day currency futures market indicates a continuing steady demand for the dollar.
* It would be difficult for major holders to abandon the dollar even if they wanted to, because of the limited absorptive capacity of the nondollar market.
In his recent book "OPEC's Investments and the International Financial System," Richard P. Mattione argued that if OPEC suddenly abandoned the dollar, "other investors might also withdraw funds from U.S. banks but that threat would also be ameliorated by market forces. Non-American banks would be unable to use all funds, deposit rates would be bid down, and the transfer would be halted." Mattione, now on the staff of Morgan Guaranty, says the same arguments would apply to any other holders of the dollar -- especially those in Europe and Canada, whose portfolios are vastly larger than OPEC's ever were.
Volatility in the currency markets in the past 10 years has increased tolerance for exchange rate shifts, reducing the possibility that some overnight fluctuation could touch off a panic. "What's your definition of dramatic?" asked Roger Kubarych, a foreign-exchange expert who is chief economist for The Conference Board. "Once a 10 percent overnight shift in the deutsche mark rate would have been unthinkable, but it's 1985 and now we're all consenting adults."
In a typical comment, David C. Batten, a managing director of First Boston Corp., said, "Over a period of time, I would expect to see funds continue to flow out of dollars as Western Europe picks up economically and the general business honeymoon with the Reagan administration cools off. There will be a gradual erosion, but no fast bailout. Too many investors have a large vested interest in the dollar. And if they want to sell, the amount they can get out without a huge impact is small. They can't move it all."
"It's a fallacy to think foreigners are going to pull their dollars out and undermine the institution," said Edward Sonnino, a portfolio manager at MAS Securities in New York. But he added that "most probably, the dollar is going to go down. I would advise anybody with a currency position in the United States to get out of it."
Some economists, such as Kemper's Hale, are concerned that the high dollar has trapped this country in a vicious cycle that eventually must undermine the economy. Foreign dollar holdings, Hale says, are financing the trade deficit, which is running at an annual rate of $133.9 billion. The strong dollar increases the demand for imports, thereby increasing the flow of the dollar out of this country into the hands of foreigners willing to take dollars in payment for their goods. But this continues to weaken domestic industries, so that "we are creating a large external debt while running down the very export industries we need to service the debt," Hale said.
Hale and others say that this must lead to a point at which foreign investors decide they have enough dollars, and the value of the currency inevitably will start to slide -- eventually restoring U.S. industrial competitiveness, but reducing the supply of foreign capital available to finance the federal deficit and corporate expansion.
Unless this pattern is accompanied by a substantial reduction in the federal deficit, economists and currency traders say, there is bound to be upward pressure on interest rates as foreign capital flows ebb.
At the end of 1984, according to Treasury figures, foreign private investors held $193.1 billion of a total of $1.212 trillion in privately held U.S. public debt securities. Foreign willingness to continue acquiring these Treasury securities is widely viewed as essential if the current downward slide in interest rates is to continue. On the other hand, higher U.S. interest rates would again enhance the desirability of dollar investments.
Few are willing to predict the point at which these conflicting pressures will settle and the dollar will stabilize. Kubarych, who as a vice president of the Federal Reserve Bank of New York literally wrote the book on the subject, "Foreign Exchange Markets in the United States," said that "there's a band of rates that make a livable compromise between the finance guys," who want to raise funds as cheaply as possible, and the "marketing guys, who want a lower dollar."
By the end of the year, he said, the German mark should settle into that band at about 2.6 to the dollar, the Japanese yen at 210 to 230 to the dollar and the British pound at $1.30.
On Friday, the mark was trading at 3.08 to the dollar, the yen at 249.56 and the pound at $1.26.