The last big wave of European and Japanese concern about a weak dollar came after the August 1971 breakdown of the Bretton Woods System of fixed exchange rates. At that time European countries feared inflation and, not wanting to support the dollar and thereby import U.S. inflation pressures, they accepted revaluation of their currencies with some misgivings because, as always, a weaker dollar meant more difficulty in competing with vigorous U.S. traded-goods companies.

Today the situation is different. It is Asian countries that are actively supporting the dollar in order to avoid the deflationary pressure that would come with an appreciation of their currencies against it. The Europeans have joined the fray, complaining that the appreciation of their currencies, the mirror image of dollar depreciation, is "brutal." Once again, their concern is tied to worries about the competitiveness of their tradeable-goods sector, which remains the only source of growth in most of Europe.

Persistent and widespread efforts to resist currency moves are doomed to fail, and if pursued long enough, can lead to serious resource misallocation. The pain tied to the unwinding of such misallocation produces further resistance to currency adjustment, but eventually maintaining an artificial set of exchange rates becomes impossible. We have probably reached that point.

Dollar Adjustment Accelerating

In fact, dollar adjustment has been underway for some time. The trade-weighted dollar's drop by nearly 8 percent since August has brought its total fall since late 2002 to nearly 25 percent. The dollar's recently accelerating move downward has evoked more concern abroad in Europe and Asia than it has inside the United States where a beatific calm has prevailed, enshrined within the mantra that "the United States supports (the concept of) a stronger dollar, but also believes that markets should determine exchange rates." That rhetoric is aimed particularly at Japan and China, where high levels of currency intervention have prevented the drop in the dollar that markets are calling for.

There is both an irony and a danger in the position of foreign governments on the dollar's weakness. The irony lies in the fact that their policy of supporting the dollar through massive dollar-buying interventions in the currency markets has created pressures that have caused the dollar to fall still further. The danger lies with the fact that by persistently undervaluing their currencies, Asian governments in particular have created substantial resource misallocation, drawing too many resources into the traded-goods sector of their economies while neglecting production of all other goods. That policy has led to tears in Asia twice in the last fifteen years as bubbles burst in Japan in 1990 and in the Asian Tigers in 1997-1998. China may be next.

Simultaneously, the persistently overvalued dollar and low U.S. real interest rates aimed at dealing with a post-bubble environment in the United States have stimulated U.S. spending on non-traded goods at the expense of a collapse of private saving. Unwinding the strong U.S. consumption surge--the concomitant  of restoring U.S. savings to something close to normal--at the same time that the currencies of export-oriented Asian and European economies appreciate, will result in slower global growth unless Asia and Europe pursue more stimulative policies.

Reasons for a Weaker Dollar

The dollar has been falling in value at an accelerating pace over recent months for several reasons. Proximately, the dollar's recent bout of persistent weakness, despite the strong fundamentals of the U.S. economy and Federal Reserve tightening, reflects a decision by foreign central banks, especially those in Asia, to reduce their dollar buying and subsequent accommodation of rising U.S. current account deficits through purchases of U.S. Treasury securities. During the five weeks following October 1, foreign central bank holdings of treasuries rose by just $9 billion. That amounts to an annual rate of $95 billion, still substantial, but far below the U.S. annualized $600 billion current account deficit. Some of the reduced purchases of U.S. government and agency securities may reflect the decision to keep intervening in currency markets while diversifying accumulated reserves into other currencies like euros, instead of buying U.S. Treasury bills or notes or agency paper. Either way, the dollar falls with the diversification into euros and provokes protests against "brutal" exchange rate movements.

Three compelling reasons have led foreign central banks to reduce their accommodation of U.S. external deficits despite painful implications for their domestic traded-goods industries. First, and most compelling, is the simple fact that heavy dollar buying by Asian central banks to prevent deflationary appreciation of their currencies amounts to a subsidy to U.S. consumption, which, in turn, produces higher and higher U.S. current account deficits and encourages excess capacity in Asian export industries. The U.S. current account deficit measures the supply of dollars flowing into foreign exchange markets. The outcome whereby dollar buying by foreign central banks leads to the need for still more dollar buying has, over the past six months, led Asian central banks to discover that their dollar-buying efforts are destabilizing. Purchasing $1 today to prevent dollar depreciation requires purchasing $1.50 tomorrow to achieve the same goal.

The U.S. trade deficit (which constitutes the bulk of the U.S. current account deficit) averaged $51.8 billion per month during the three months ending in September. This is up sharply from the $41.4 billion monthly average during 2003. Little wonder, since as a result of heavy dollar buying by Asian central banks, the dollar has depreciated by only 2 or 3 percent against the Japanese yen over the past year and, of course, has depreciated not at all against the Chinese yuan by virtue of the Chinese government's decision to peg its currency to the dollar. This means that the currency adjustment mechanism is not being allowed to operate for the two countries with the largest (and two of the fastest-rising) trade balance surpluses with the United States ($226 billion annualized, through September).

The currency problem with China is especially acute. By virtue of the Chinese currency peg to the dollar, for practical purposes China and the United States have the same central bank--the Federal Reserve--although they require very different monetary policies. If the United States were growing at over 9 percent with inflation having accelerated rapidly to nearly 6 percent during the past six months, as has occurred in China, the Fed would surely be tightening much faster than at its current "measured" pace. Based on fundamentals, the yuan needs to appreciate while the dollar needs to depreciate. Preventing this adjustment places a great burden on other currencies such as the euro and the yen. Dollar weakness means yuan weakness under the currency peg, and yuan weakness results in further undervaluation of the Chinese currency. The yen and the euro are appreciating against the dollar and the yuan. The latter is the currency of the world's most competitive producer of traded goods--China. The resulting deflationary impact is painful for Japan and Europe to absorb.

Beyond the decision by Asian central banks to reduce their dollar purchases, two other proximate reasons help explain the enhanced weakness of the dollar over recent weeks. As the cost of oil (priced in dollars) has risen, the temptation to allow one's currency to appreciate in order to stabilize the local currency price of oil imports has increased. With the euro and the yen rising against the dollar, the price of oil measured in those currencies has risen by less as they have appreciated against the dollar. Central banks and finance ministers in Europe and Asia have acknowledged as much.

Finally, the strong reelection victory of President George W. Bush has been taken abroad as a signal, rightly or wrongly, that the U.S. government's dis-saving (budget deficits) will continue to rise, thereby obligating foreign governments to purchase even more dollars and U.S. Treasury securities if they are to accommodate larger U.S. budget deficits while pegging the dollar.

Clear Dollar Message from Bush

The actual message from the White House on the dollar seems pretty clear. The primary aim of the Bush administration is to undertake fundamental reforms to place Social Security and government health-care programs on a sounder footing by encouraging individuals to save more on their own while working actively with health-care providers to contain rapidly rising costs. Revenue-neutral tax reform aimed at enhancing efficiency by lowering marginal tax rates and closing loopholes is also on the agenda. These important reforms will allow markets to work better to enhance the long-run growth path of the U.S. economy and to boost U.S. savings, and thereby they will cut pressures for a higher current account deficit. But while undertaking these measures, the Bush administration is also prepared to let markets determine exchange rates. That means that European and Japanese pleas for the U.S. government to join in intervention efforts to stabilize the dollar will go unheeded. Their choice comes down to either allowing the dollar to adjust or buying ever-increasing quantities of dollars--a move that eventually will prove inflationary.

The second message to governments in Europe and Japan who fear the deflationary impact of further appreciation of their currencies against the dollar is to press the Chinese to allow the yuan to float upward. China's peg to the dollar has meant that its currency has depreciated rapidly along with the dollar. Inflation pressures in China have increased while the cost of oil imports for China's heavily oil-dependent export industries has increased as well. The peg has destabilized China's domestic economy. Higher inflation and pegged interest rates leading to potential disintermediation in China's inflexible financial system have already forced the Chinese government to begin to allow interest rates to begin to rise. Chinese savers do not want to earn 2 percent on bank deposits while 6-percent inflation erodes the purchasing power of savings. China's recent move toward greater flexibility of interest rates seems to portend more overall flexibility in China's financial system. That will include currency appreciation in order to reduce its need to purchase dollars while simultaneously cushioning its oil-dependent economy from higher petroleum prices. Even a moderate 10 or 15 percent revaluation of China's currency, perhaps through a transition to a Singapore-style currency basket, would ease the pressure for dollar weakness against the other currencies like the euro, the yen, and the currencies of Korea and Taiwan.

The reluctance of America's trading partners to allow dollar depreciation, even as the U.S. current account deficit has grown to a point where nearly $2 billion a day must be purchased in order to keep the dollar stable, has created a massive global imbalance. U.S. consumption is being artificially elevated to support rising excess manufacturing capacity in Asia and Europe. Although adjustment will involve some transitional pain, the emergence of a virtually zero saving rate in the United States, while Chinese investment rises at a 40 percent annual rate, is not sustainable. Another year of dollar pegging will mean a U.S. current account deficit of more than $700 billion and a negative U.S. saving rate.

Choosing a Positive-Sum Policy Response

In the thirty-three years since the last episode of dollar weakness that provoked widespread global protests, we have moved from the Bretton Woods era of pegged exchange rates to an era of intermittent "dirty floating" where exchange rate changes are sometimes acceded to and sometimes resisted. In late 2004, after three years of U.S. fiscal and monetary stimulus that has sustained global demand and output growth while U.S. public and private dis-saving has surged, the Fed is raising interest rates, and the U.S. budget deficit is falling again. A weaker dollar is a normal response to the U.S. growth slowdown that is accompanying the rapid withdrawal of policy stimulus.

U.S. trading partners have several options: stimulate their economies with easier monetary and fiscal policies; undertake ever-increasing dollar purchases that will exacerbate global imbalances and result in even larger U.S. current account deficits; or accept sharp dollar depreciation (deflationary appreciation of their own currencies). The first option may not simply be available to China, which can mitigate currency appreciation by relaxing controls on capital outflows and unleashing its huge stock of accumulated savings to seek higher returns in global markets. However, only the first option, more policy stimulation in Europe and Japan, can turn the scenario of global rebalancing with a weaker dollar into a global positive-sum game.

John H. Makin is a visiting scholar at AEI.