Forecasts of economic apocalypse usually are — like antemortem reports of Mark Twain’s death – greatly exaggerated.
Think back a couple of months to when reports of the declining value of the U.S. dollar were making headlines. Many journalists instinctively report such declines in our currency’s value as bad news. However, academic and industry economists whose views were cited in news reports generally were more sanguine.
They noted that a less costly dollar would have positive effects on any U.S. producers who export, i.e. farmers and medical device manufacturers, or who compete with imports, i.e. the U.S. auto and steel industries. They also generally said declines in the value of the dollar relative to the euro were merely reversing a dramatic strengthening of the dollar that had taken place about three years earlier.
Many analysts had noted for months that the dollar was overvalued relative to European and Japanese currencies. Some eventual decline was highly likely, if not inevitable. In summary, the dollar hitting “historic lows” against the euro was nothing to lose sleep over.
Some Wall Street economists, however, took sharp exception to this complacency.
They spun near-catastrophic scenarios. A decline in the value of the dollar means that the own-currency value to foreign owners of U.S. stocks and bonds drops, even when the dollar prices of these securities does not change. Foreign investors in U.S. markets would look at such declining values and bail out.
Mass selling by foreigners would push U.S. stock and bond markets into strong decline, and when the dollars resulting from the sales were dumped into foreign exchange markets, the decline in the exchange value of the dollar would accelerate. Outflows of foreign funds from U.S. equity markets would drive up interest rates for businesses and households. That would choke off investment in new plants and equipment for the first and consumption spending for the latter.
Our economy would slide into deep recession. The whole cycle might be repeated again and again till we were back to the situation faced in the spring of 1933.
This hasn’t happened yet. In fact, U.S. stock markets had some of their best performance in many months in the weeks since some of these catastrophic predictions were printed. Why haven’t these catastrophic predictions come true?
It is too early to tell exactly what has happened, but let me suggest an alternative scenario.
As the U.S. dollar declined, foreign investors did see declines in the own-currency values of their portfolios of U.S. stocks and bonds. Some reacted by selling. Others did not. But, while declining euro or yen values of U.S. securities motivated some existing owners to sell, these effective lower prices gave an incentive to other potential foreign investors to buy. Stronger euros or yen bought more shares than before the dollar decline began.
Moreover, people who invest across national borders generally are more sophisticated than the small punter who buys 100 shares at a time. Most international investing is done by large financial institutions. Such firms had long been aware that the U.S. dollar probably was overvalued relative to the euro or yen.
They knew well in advance that some decline was likely and had factored this into their buy-hold-sell decisions long before the dollar’s slide materialized. A domestic stock purchase is a bet on the future performance of a particular company. An investment in the same stock by someone outside the U.S. is not only a bet on the company’s performance but also on the future evolution of relevant exchange rates. International investors know this.
They also know that history, and the economic theory pioneered by recently deceased economist Rudi Dornbusch, have shown that when exchange rates move, they usually overshoot a new equilibrium point and then come back. Apparent extreme moves don’t always warrant panic.
Finally, such investors looked not only at what was happening to their U.S. investments, but also at what they could put sale proceeds into at home if they decided to bail out of the United States and repatriate their money. The decrease in the value of the dollar relative to other currencies that would provide a boost to U.S. producers would strike a blow at the prospects of foreign competitors. Forecasts of economic growth in Germany and other E.U. countries have dropped sharply as the value of the euro has risen. Selling stock in U.S. firms with improving business prospects to buy stocks in E.U. firms with declining outlooks would be stupid.
The upshot is that we have not seen any catastrophic vicious circle of foreign capital fleeing the United States and we are not likely to.
The great 19th century English economist Alfred Marshall opened his famous Principles of Political Economy with the Latin epigram natura non facit saltum — nature does not take leaps. Marshall saw that nearly any movement within an economy engendered some compensating forces that would naturally and eventually bring the initial movement back to a rest.
Economies are not static. They grow and they fluctuate. Fluctuations may be painful to some households. But economies seldom “take leaps.” Most change occurs gradually over time. Catastrophes are rare, and when examined in retrospect, as we have examined the Great Depression, are usually due to an unusual confluence of several bad policies.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.