Central bankers, finance ministers and international economists gathered in Washington yesterday to resume their quest for a truth as elusive as the origins of the universe or the secret to a happy marriage: the appropriate value for the U.S. dollar.
Looked at from one angle, the dollar, which has risen sharply against the yen and most European currencies in the past year, is now overvalued. The "high" dollar makes imports so cheap to American consumers -- and makes American goods so expensive on world markets -- that it threatens to slow the U.S. economy and send the trade deficit soaring.
On the other hand, as any American traveler has surely noticed, the dollar in Tokyo or Paris buys much less than in New York or Washington. From that vantage point -- what economists call "purchasing power parity" -- the value of the dollar is too low.
So who's right?
One of the big problems with the dollar is that it has become the black box of economics. In many cases, it is difficult to tell whether the dollar is the cause or the effect of some economic phenomena. And as often as not, it's hard even for experts to predict whether a development will cause the dollar to go up or down.
Indeed, it's not even clear whether Americans should favor a stronger dollar or a weaker one. American consumers benefit from a strong dollar because it lowers the price for the many goods that we import. But because most Americans are also producers, a weak dollar helps to create jobs by making our products cheaper on global markets. Balancing the interests of workers and consumers is the essence of dollar politics and explains why the Treasury is often so mealy-mouthed on the issue.
One person who follows the dollar closely is Professor Ronald McKinnon of Stanford University. McKinnon regularly calculates what it costs in dollars to buy a basket of wholesale goods in various countries. In the past, McKinnon's index has shown that the dollar has been badly undervalued, meaning that it buys less over there than it does here. But now, with the recent run-up, McKinnon finds the dollar appropriately valued.
Unfortunately for Americans traveling abroad, there is a big difference between McKinnon's wholesale prices (of a commodity such as wheat) and retail prices (such as of a croissant made from wheat flour and served at a Parisian cafe). To begin with, the retail price is loaded with a 15 percent value added tax that substitutes for the income tax in much of Europe. And, despite its obvious charms, the French cafe is less efficient and pays its waiters much higher wages and benefits than the Au Bon Pain in downtown Washington. The result is that the simple croissant becomes a luxury item to the American visiting Paris.
In other countries, this effect can work in the other direction. In dollar terms, a Ford Contour costs about the same whether delivered to the docks in Bombay or Seattle, give or take differences in shipping costs. But because Indian taxi drivers earn lower wages than American cab drivers, a cab ride across Bombay seems like a real bargain for a traveling American.
It is because of these variations in wages, productivity and efficiency in the domestic, or non-traded, sectors of the economy that the purchasing power of the dollar varies so much from country to country. And while free trade has roughly equalized the price of traded goods, other things cannot be easily traded or equalized in price. As a result, "purchasing price parity" does not offer a very helpful guide to the "right" value of the dollar.
What about the other theoretical candidate as a dollar benchmark, the "fundamental equilibrium exchange rate"?
According to this theory, the value of the dollar over the long term should rise or fall in response to trade flows in and out of the United States. Or put another way, floating exchange rates serve as the global economy's self-correcting mechanism, evening out the trade imbalances.
In many respects, this theory has been born out by experience. For each of the last 20 years, the United States has consumed more than it has produced, generating ever increasing trade deficits. And over the same period, the trade-weighted value of the dollar fell nearly 20 percent.
But a number of studies have shown that while this relationship between trade balance and currency value holds up over the long term, it is not particularly useful in predicting the direction of the dollar or the trade balance over shorter periods of time. The reason has to do with investment flows.
It turns out that many of those foreigners who sell us running shoes and crude oil in exchange for dollars don't run out and exchange those dollars back into their own currencies. Instead, they use those dollars to buy U.S. stocks, bonds and real estate. This willingness to "finance" our trade deficit has been a great boon to the U.S. economy and Wall Street. But it has also kept the value of the dollar artificially high, short-circuiting the process by which exchange rates bring the trade accounts back toward balance.
This is particularly true today. Because the U.S. economy is booming while the economies of Japan and Europe are barely limping along, interest rates and stock market gains are significantly higher here than abroad. With those premiums, investors from around the world are eager for dollars and the U.S. stocks and bonds that they can buy with them.
But according to economist Robert Lawrence of Harvard University, the fact that it takes such generous premiums to lure investors from other currencies to the dollar does not necessarily bode well for the greenback's future. Once growth rates pick up in Japan and Europe and the interest rate gap closes, investors are almost sure to reverse course with equal enthusiasm. The rush to sell dollars on currency markets will drive down the price. When will it happen? How steep will the fall be? What is the right level for the dollar now? Given the contradictory theories and the gap between theory and experience, Lawrence won't even hazard a guess. "I'm much more humble than I once was about pronouncing on the dollar," he said. CAPTION: DOLLAR VS. YEN (This chart was not available)