[Mb-civic] An article for you from an Economist.com reader.

Wed Dec 29 15:56:39 PST 2004

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THE EURO
Dec 29th 2004  

The dollar has hit another record low against the euro. It is set for
further falls against major currencies in the coming year, even though
American interest rates will rise

FORECASTING exchange rates, warns Alan Greenspan, the chairman of the
Federal Reserve, has a success rate no better than calling the toss of
a coin. But the dollar keeps coming up tails. At the start of 2004,
holders of America's currency had to part with $1.25 to buy a euro. At
year's end, they must fork out another dime or more. On Wednesday
December 29th, it cost over $1.36 to buy a single euro, a fresh record.

The cause of the dollar's decline is hardly a mystery: private
investors have become less eager to finance America's huge
current-account deficit. The deficit widened slightly in the third
quarter of 2004, to a record $165 billion, or 5.6% of GDP in that
period. 

These record deficits are adding to America's foreign debts at an
alarming rate. But as yet, America still earns more from its foreign
assets than it pays on its foreign liabilities. That is about to
change. As interest rates rise, refinancing America's debt will become
more costly. Goldman Sachs forecasts that net foreign-investment income
is likely to shift to a sizeable deficit during 2005, growing
thereafter. The investment bank estimates that, if America's
current-account deficit remains steady as a share of GDP and interest
rates average 5% in future, net foreign debt-service payments will
reach 4% of GDP by 2020--a significant drag on American living
standards.

To avoid shelling out such large sums to foreigners, America will,
ultimately, have to rely more on its own savings and less on savings
imported from abroad. The country as a whole saved just 1.7% of
national income in the first nine months of 2004. Households saved just
0.7%.

The dollar's decline may force America to embrace thrift, argues
Goldman Sachs. As the dollar falls, foreigners will demand more
American goods. This will put pressure on America's manufacturers,
which are already operating at 78% of capacity. As supply is stretched,
inflationary pressures will build. The Federal Reserve will raise
interest rates, curbing domestic demand, and thus creating room for an
export boom. The higher interest rates will thus promote the saving
America has so sorely lacked.

This process has barely begun. Over the past two years, the dollar has
lost almost 23% against the euro. But it has shed less than 13% against
a broader basket of currencies (see chart), and it has not lost a cent
against China's yuan. As a matter of official policy, the Chinese
currency has remained within a tight range around 8.28 to the dollar
for the past decade. Forecasting the intentions of China's policymakers
may actually be harder than calling a toin coss. But many are trying.
Offshore markets, for example, allow speculators to make a bet on the
value of the yuan in 12 months time. At the moment, punters reckon you
will get just 7.8 of them for your dollar this time next year.

Against the yen, the dollar is actually slightly stronger than it was
in late November. The Bank of Japan has not intervened in the
foreign-exchange markets since March, but the threat to do so remains.
Japan's finance minister, Sadakazu Tanigaki, gave warning this week
that his country's authorities would monitor foreign-exchange markets
over the New Year holiday, a time when trading is thin and official
buying can make a big difference.

If Japan's finger is on the trigger, the European Central Bank (ECB)
seems prepared to sit on its hands. Jean-Claude Trichet, president of
the ECB, has lived with strong currencies before. As president of
France's central bank in the years before euro entry, he was dubbed
"the ayatollah of the FRANC FORT" for his unflinching support of a
strong national currency. Indeed, for much of 1995, a weighted basket
of the franc and the 11 other currencies that formed the euro was worth
almost as much against the dollar as it is now.

In his press conferences, Mr Trichet has made it clear that recent
rises in the single currency are unwelcome. But he has dwelt at greater
length on the danger of rises in energy prices. His chief duty, as he
sees it, is to convince firms and workers that inflation will remain
well contained, despite the oil price spike of the autumn. It is a
confidence game: if he can convince them an inflation spiral won't
happen, then it won't. The strong euro will actually add to his
credibility, by curbing the price of imports.

Besides, the hard men of hard money believe that weak currencies make
life too easy for firms and politicians. Devaluing the currency
provides an unsatisfying alternative to deregulating and restructuring
the economy. An overvalued currency, on the other hand, leaves
uncompetitive firms and tentative politicians with "no place to hide",
as Eric Chaney of Morgan Stanley puts it. They must reform or perish.

"You cannot devalue your way to prosperity," says John Snow, America's
treasury secretary, somewhat hypocritically. The year to come may
reveal whether Europe can revalue its way to the same end. 

See this article with graphics and related items at http://www.economist.com/agenda/displaystory.cfm?story_id=3524771

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