The latest threat to America's economic boom is a weaker dollar. A weaker what?
By and large, Americans don't pay attention to exchange rates. Why should they? At any moment, only a tiny fraction of Americans go abroad and are aware of different currency values. As a result, few realize that a strong dollar has favored the boom -- and that a weaker dollar could undermine it. To understand why shows how the economy's good fortune depends on murky forces that are not easily controlled.
Consider how the strong dollar has helped. Between April 1995 and June 1999, the dollar rose 28 percent against an index of currencies of 34 countries. This meant that Americans could buy imports less expensively. Cheap imports in turn helped hold down inflation and interest rates. Consumer buying power and borrowing rose. Strong spending offset the depressing effect of larger trade deficits. Indeed, America's huge appetite for imports aided struggling economies in Europe, Asia and Latin America.
For the United States, a virtuous circle ensued. High profits and stock prices attracted foreign investment. In 1998 private foreign investors bought $265 billion worth of U.S. stocks, bonds and other securities, estimates the Commerce Department. They also made $196 billion in "direct investment" -- funds to build factories and offices or buy U.S. companies. These investments propped up U.S. stock prices and the dollar's exchange rate (foreigners sold their currencies to buy dollars).
Now, suppose the dollar weakens significantly. The process could swing into reverse. Imports become more expensive. Inflation worsens a bit. Consumer spending suffers. Foreign economies export less and do less well. A weaker economy might also make the United States less attractive to foreign investors. This might depress the stock market. With foreigners buying fewer dollars (for stocks or direct investments), the dollar's exchange rate might slip further.
Hardly anyone expects a full-scale currency crisis. This would happen if investors lost confidence in the dollar. Then they'd dump dollar investments and convert their funds into other currencies. The dollar would plunge. Asian currencies suffered this fate in 1997. But the dollar isn't the Thai baht.
As for a milder drop, the odds are unclear. In recent weeks, the dollar has declined. Some economists think it will go farther. The investment banking firm of Goldman Sachs forecasts it will fall about 13 percent against the euro and 10 percent against the yen in the next year. But there's no consensus. Other economists think that the dollar -- despite fluctuations -- is in the midst of a long upward move, reflecting low inflation and better economic prospects in the United States than in Europe or Japan.
Disagreement is easy to explain: Exchange rates react to so many influences that it's hard to know which will prevail. In most economies, trade flows were once decisive. A large trade deficit caused a country's currency to lose value. Exports didn't generate enough foreign exchange to pay for imports; traders had to sell more local currency to buy foreign currency. This imbalance depressed the currency's value. If that were all that mattered, the dollar would now drop sharply, because the U.S. trade deficit has mushroomed. Between 1997 and 1998, it jumped from $198 billion to $248 billion, and it continues to rise.
But exchange rates also increasingly respond to capital flows -- shifts of investment funds across borders. These have recently favored the dollar. In 1998, Americans invested about $298 billion abroad. (This sum includes the purchase of foreign stocks and bonds, direct investments and bank loans to foreigners.) But foreign private investors put $565 billion in the United States. Many regard the United States as a stable "safe haven." Still, any shift in capital flows away from American investments could hurt the dollar.
Finally, foreign exchange traders -- banks, investment houses, companies -- buy and sell currencies just like stocks. The volume is huge. In 1998, currency trading averaged $1.5 trillion a day. Traders constantly guess which way a currency will go in an effort to make a quick profit. Their frenzied trading sets daily currency rates and explains why foreign exchange markets can "overshoot": Rates go higher or lower than trade or capital flows justify. Sooner or later, distorted rates trigger market "corrections" just as overvalued or undervalued stock prices do.
All this is a cautionary tale. We don't know where the dollar is headed and what the effects will be. For example, a lower dollar would also aid U.S. exports by making them more competitive. This could spur the economy. The larger lesson is that the economic boom resembles a finely tuned machine. All the parts must work smoothly for the machine to run fast. Low inflation sustains optimism and strong consumer spending. This bolsters corporate profits, investment and stock prices. Good growth attracts foreign investment, which keeps the dollar strong. If any part breaks or weakens, the machine will slow. It might even -- unhappily -- slip into reverse.