How The Mighty Hath Fallen:

The Inexorable Slide of the U.S. Dollar

The U.S. dollar, which has defied gravity for an exceedingly long time, has, this month, begun to display signs of receding from its previously lofty position. Whereas the decline (to date) has been measured at best, it is reflective of certain fundamental conditions. I had argued previously ("Why the Alps Tower the Rockies") that this would be due to a shift in prevailing economic conditions, premised on the weakening of the American economy in general. This remains true to a large extent, and several developments over recent months have reinforced the case.

First, the productivity paradox/miracle has started to look more and more tired. The latest data to emerge from the U.S. Bureau of Labour Statistics (Madrick 2001) has lent support to Robert Gordon's (1999) school of thought that the productivity rise was largely cyclical and hence misleading. In a sense, this seems to have been precluded by the stock markets - the S&P 500 has slid close to its lowest levels all year, the Dow has slipped through 10,000 once again, and the NASDAQ - well, we know about the NASDAQ. Adding fuel to the flame, the previously fat budget surplus has withered to anorexic proportions, making previous growth estimates look overtly optimistic.Adding fuel to the flame, the previously fat budget surplus has withered to anorexic proportions, making previous growth estimates look overtly optimistic. As these dismal findings shake and eventually get digested by the markets, the last of the Internet euphoria will dissipate, allowing capital to flow to previously ignored markets elsewhere and shoring up the strengths of other currencies.

Second, the U.S. current account deficit looks to be even more precipitous. Whereas apologists for the sustainability of the $450 billion (4.5 per cent of GDP) exist (Quinlan & Chandler 2001), the truth of the matter is that such stunning trade deficits cannot be justifiably sustained indefinitely. Whether or not the no-Ponzi game condition held in the New Economy bubble, foreigners are progressively unwilling to fund the spending patterns of U.S. consumers. More ominously, the U.S. current account deficit now stands at a level not dissimilar - and in some cases exceeding - that of the economies of East Asia prior to the 1997 Asian financial crisis. Apprehension over the state of affairs has not gone unnoticed at the highest levels - witness the recent IMF criticism that "the size and duration of the current account deficit... raise concerns that the dollar might be at risk for a sharp and sustained depreciation" (IMF 2001, p. 25).

Third, the concerted decline of the dollar against all currencies, and not just against a singular currency such as the yen, provides additional reason to believe that capital is truly flowing elsewhere. The U.S. economy is no longer the paragon of economic strength that it once was. The formal introduction of euro notes and coins in 2002 will further erode the use of the dollar as a reserve currency as the euro becomes more firmly entrenched in the international financial landscape. And if economists such as Sinn & Westermann (2001) are to be believed, the use of the euro in physical form will ease the entry of black-market European currencies (especially the Deutschemark) into general circulation, injecting fresh liquidity into the system and buttressing the use of previously locked-out capital.

The slide has hitherto, arguably, been small - the dollar changes hands at about 0.92 dollars to the euro, and some 120 yen buys a buck. Indeed, the relative size of the decline prompts one to question the forces that kept the dollar out of whack - was it a mere case of currency overshooting, a la Dornbusch (1976)? Or has it been more of a slow reversion to Purchasing Power Parity?[1] In the absence of new data and directed empirical research, the question remains open.

Still, it is not premature to venture that the recent decline is a combination of mean reversion to PPP coupled with some short-term overshooting, especially in response to the productivity 'miracle' and the dot-com boom (bubble). But regardless of the specific hypotheses that will no doubt arise in attempting to explain the strong-dollar puzzle, the points raised above can only mean that the chimera [2] of Mr. O'Neill's 'strong-dollar' policy has most definitely been hurt, if not slain, and it is likely that the future will increasingly see it finally being buried.


Dornbusch, R. (1976). 'Expectations and Exchange Rate Dynamics', Journal of Political Economy 84 (December): 1161-76.

Froot, K.A. & K. Rogoff (1995). 'Perspectives on PPP and Long-Run Real Exchange Rates'. In Handbook of International Economics 3, edited by G. Grossman & K. Rogoff. Amsterdam: North-Holland.

Gordon, R.J. 'Has the "New Economy" Rendered the Productivity Slowdown Obsolete?' Mimeograph. Evanston, IL: Northwestern University, 1999.

International Monetary Fund (2001). ‘United States: 2001 Article IV Consultation – Staff Report, Staff Statement, and Public Information Notice on the Executive Board Discussion’, IMF Country Report no. 01/145.

Lim, J.J. (2001). 'Why the Alps Tower the Rockies'. Mimeograph. Online:

Madrick, J. 'Revised Productivity Figures Disprove Beliefs of New Era', International Herald Tribune, Aug 31, 2001.

Quinlan, J. & M. Chandler (2001). 'The U.S. Trade Deficit: A Dangerous Obsession', Foreign Affairs (May/Jun).

Sinn, H.W. & F. Westermann (2001). 'Why Has the Euro Been Falling? An Investigation into the Determinants of the Exchange Rate', NBER Working Paper no. 8352.

Taylor, A.M. (2000). 'A Century of Purchasing Power Parity', NBER Working Paper no. 8012 (forthcoming in Review of Economics and Statistics).


1. It is generally acknowledged that mean reversion to PPP occurs after 3-5 years (Froot & Rogoff 1995). There has been the contention that PPP has shown greater persistence in recent times, although Taylor (2000), employing a barrage of empirical tests, has not found any evidence to that effect.

2. The strong dollar policy can be credibly described as a mirage, because despite the widespread rhetoric of the Bush administration in maintaining such a policy, actual policy moves have not justified such a belief. 'Letting the market decide' can hardly be described as anything more than a tacit endorsement of market forces, and not a strong-dollar policy per se.

This article is unpublished.