macroeconomics, dollars, decline, account balance, GNP, domestic demand

Stephen N. Marris

English

Research Papers in Economics

STEPHEN  N.  MARRIS 
Institute for International Economics 
The Decline and Fall of the Dollar: 
Some Policy Issues 
IN Dollars and Deficits:  The World  Economy at Risk, ' I have set out the 
empirical  analysis that  has led me to conclude not only that a decline in 
the dollar  is inevitable,  but also that, absent major  changes  in policy by 
both the United States and its allies, the dollar  will fall over a period  of 
perhaps  two to four years to a level below its previous trough  in 1980. 
As measured  by the International  Monetary  Fund  Multilateral  Exchange 
Rate Model (MERM)  index, it would fall, in a hard landing, by more 
than  40  percent  by 1989,  and  the deutsche  mark  would  appreciate  against 
the dollar  by over 90 percent.  This paper  considers  the policy issues that 
would face the United States and its major  allies if such a hard  landing 
were to materialize. 
The figures  cited here come from simulations  of a model developed 
for my book. It is a relatively simple model of how growth rates and 
relative price changes influence the U.S.  current account balance on 
goods and nonfactor  services, and how the latter generates  changes in 
the U.S.  net investment position and net investment income. It also 
incorporates  feedback from the exchange rate on domestic prices, and 
from net exports on GNP and domestic demand, in both the United 
States  and  the rest of the world.  The properties  of the model  with  respect 
to a decline  in the dollar  are  in broad  terms  similar  to those of the Federal 
Reserve  Board's  Multicountry  Model  and  the  Organization  for  Economic 
Cooperation  and  Development's  interlink  model, and  to the widely used 
rule  of thumb  that a 1 percent decline in the dollar, as measured  by the 
MERM  index, leads to a $3 billion  improvement  in the current  account 
balance. 
An important  feature of the model is that it makes no attempt to 
237 
1.  Institute for International Economics,  forthcoming. 238  Brookings Pavers  on Economic Activity. 1:1  985 
endogenize  the  two  key financial  variables,  the  exchange  rate  and  interest 
rates.  Models  that  purport  to do so have  performed  badly  and  are  unlikely 
to be able to track  the unraveling  of an exchange rate disequilibrium  of 
the magnitude  we are now experiencing.  Instead,  the exchange  rate  and 
interest rates have been projected exogenously on the basis of an 
empirical examination of how they behaved in the past at times of 
financial  stress and  marked  changes  in exchange  rate  expectations. 
The Implausibility  of Soft Landing Scenarios 
The basic reason for the implausibility  of the various soft landing 
scenarios that have been suggested is less a matter  of analysis than of 
simple arithmetic.  It lies in the magnitude  of the initial  disequilibrium, 
and  hence in the size of the shifts in both the U.S. domestic investment- 
saving  balance  and  current  account  balance  needed  to restore  sustainable 
equilibrium. 
In one version of the soft landing  scenario-appealing particularly  to 
academic economists-the  dollar declines no faster than could be 
covered  by a "reasonable"  interest  rate  differential.  But if, for example, 
the dollar  were to decline at 3 percent a year, it would take twenty-two 
years to eliminate  the U.S. current  account deficit, by which time U.S. 
external indebtedness would have risen to over $5.5 trillion. With a 
dollar decline of 5 percent a year, the corresponding  figures  would be 
fourteen years and $2.3 trillion.  Apart  from the intrinsic  implausibility 
of these debt figures,  these scenarios  imply  that, over a decade or more, 
either  real U.S. interest  rates would have to be at least 5 percent  above 
the potential  U.S. growth  rate, in which case achieving such a growth 
rate becomes highly unlikely; or real interest rates in other countries 
would have to be at least 5 percent below their growth  rates, in which 
case  these countries would suffer from virulent inflation; or some 
combination  of both, which would not be much  less implausible. 
In a second version of the soft landing  scenario, it is assumed that, 
while it is unlikely  that  capital  inflows  will go on rising  indefinitely,  there 
is no reason why they should  not still be running  at, say, 1 to 2 percent 
of GNP in 1990.  With  the U.S. economy growing  as in the Congressional 
Budget Office (CBO) baseline, however, it would take a drop in the 
dollar  of around  35 percent to hold the current  account deficit  down to Stephen N. Marris  239 
this level. And, in the meanwhile,  U.S. net external  indebtedness  would 
have risen to $700-800 billion. In other words, some asset holders, 
somewhere, would have to be induced to increase their exposure in 
dollars  by $800 billion  at a time when, for example, the deutsche mark 
would be appreciating  against  the dollar  by something  like 75 percent. 
Once these orders of magnitude  have been taken into account, it 
becomes evident  that  once the dollar's  decline  gathers  momentum,  there 
is bound to be a significant  period of time, perhaps  twelve to eighteen 
months, when people's willingness  to increase  their  exposure in dollars 
will be declining,  ex ante,  faster  than  the U. S. economy's need  for  capital 
inflows  to make  up for its deficiency  of domestic saving.  There  will thus 
be a "crunch" in the financial  markets, and, as a fairly conservative 
estimate, U.S. interest rates will rise 5 percentage  points above what 
they would otherwise  have been. 
The Hard Landing Scenario 
In my hard  landing  scenario,  the U.S. economy suffers  a recession of 
about  the same  magnitude  as that  incorporated  in the CBO's  low-growth 
medium-term  projection. In other respects the recession is, however, 
quite  different  from that depicted by the CBO, because it is associated 
with a steep decline in the dollar. The projection of how much U.S. 
interest  rates are pushed  up in this scenario  by efforts to sell off dollar- 
denominated  assets is based, in part, on an estimate that interest rates 
were held down by at least 5 percentage  points by capital  inflows  in the 
period  1983-84,  when the dollar  was appreciating  strongly.  Despite this 
rise in interest  rates, the dollar  "overshoots"; present  and prospective 
holders of dollar-denominated  assets experience exchange rate losses 
estimated  at $400  billion  in terms  of a MERM-weighted  basket  of foreign 
currencies  (a good deal more  in terms  of deutsche marks  or yen); and  by 
1990  the ex ante desire to get out of dollars has produced  an ex post 
capital  outflow  equivalent  to 1.5 percent  of GNP. 
In this scenario,  interest  rates in other  OECD  countries  decline by 2- 
3 percentage  points because of the ex ante reflux of capital from the 
United  States. In other respects, however, these countries  follow their 
present policies, in particular  their restrictive fiscal policies. With a 
reversal  of the positive stimulus  to demand  that  they have been enjoying 240  Brookings Papers on Economic Activity, 1:1  985 
from the United States, they find themselves pushed into a growth 
recession, with GNP growth averaging  under 1 percent in the period 
1987-88.  The model also incorporates  a negative  feedback  on growth  in 
the less developed  countries  (LDCs)  resulting  from  low OECD  growth: 
Policy Options Facing the United States 
In this hard landing scenario, the United States will be facing a 
prospect quite unique in its postwar history: a recession generated  by 
the pressures  of the external adjustment  mechanism.  The unusual  and 
unpleasant  feature will be an incipient  recession accompanied  by high 
interest  rates and accelerating  inflation,  which, after  twelve to eighteen 
months,  might  roughly  double  to the 6 to 7 percent  range.  In  terms  simply 
of the market  forces at work, a recession might  not be inevitable:  with 
the dollar  falling sharply,  the negative impact  on demand  coming  from 
high interest rates might  fairly soon be offset by a stimulus  from rising 
net exports. But this arithmetic  does not take into account  the likelihood 
that  the necessary  policy response  to the evolving situation  would make 
a recession unavoidable. 
One possibility  is that the dollar  falls so fast and so far that it quickly 
reaches a level at which expectations stabilize and U.S. interest rates 
fall back to normal  levels. But, again,  the numbers  and  past experience 
suggest that it could fall 40-50 percent before reaching  this point. And 
this would  pose a high  risk  of an inflationary  explosion. 
What about fiscal policy? What  few seem to realize is that at some 
point in the near future, people's ex ante willingness to increase their 
exposure in dollars  is going to fall to zero and, indeed, turn  negative. At 
that  point, crowding  out in U.S. financial  markets  will become inevitable 
unless, by then, the structural  budget  deficit  has been reduced  to around 
zero. Since this point may not be more than a year or so away, this is 
clearly impossible. In other words, there is now no way in which the 
United States can get its fiscal sums right  because they have become so 
heavily dependent on what has become the most fickle of economic 
variables:  exchange  rate expectations. 
If, contrary  to all the political signs, strong action were taken quite 
quickly  to reduce  the deficit,  the day of reckoning  might  be postponed- Stephen N. Marris  241 
but not for long. Still, there is a powerful  case for taking such action, 
especially if it could be taken  before the crunch  came, because it would 
give the Federal  Reserve Board  (FRB)  more  room  to maneuver  and  thus 
make  the dollar's  decline more  manageable. 
What about monetary  policy? One school of thought  argues that if 
action were taken to cut the budget deficit and if, then, the economy 
seemed to be slipping  into recession, the FRB should  ease up. But this 
argument  completely ignores the unique  features of an externally  gen- 
erated  recession: strong  upward  pressure  on interest  rates, accelerating 
inflation,  and a rapidly  falling dollar. The FRB will face an impossible 
choice. If it strictly  pursues  its monetary  targets,  high  interest  rates will 
push the economy into recession and entail serious risks of a major 
financial  crisis as debtors  are sharply  squeezed in the United States and 
the developing  world. If, on the other hand, the FRB eases up in order 
to keep interest rates from rising too much, the perception that it is 
prepared  to monetize both the budget deficit-which  would be rising 
toward the $400 billion mark-and  the external deficit would greatly 
alarm  both  the financial  markets  and  the  foreign  exchange  market.  There 
would be a clear danger  of a self-feeding spiral of eroding  confidence 
between the two markets, adding greatly to the upward  pressure on 
interest  rates and the downward  pressure  on the dollar. 
Once again, because of the magnitudes  involved, there will, in the 
event, be no way for the Federal  Reserve to square  this circle. All that 
can be said is that from the point of view of the longer-run  interests of 
the United States and  the world  economy as a whole, it would probably 
be best if it errs  on the anti-inflationary  side. 
A Cooperative  Scenario 
The upshot of this analysis is that there is now nothing that U.S. 
authorities  can do to prevent a hard  landing. Still, such an outcome is 
not inevitable. In theory, at any rate, it could be avoided if both the 
United States and its major allies were to undertake a prompt and 
simultaneous  change  of policies. 
Analysis  of a "cooperative" scenario,  in which the rest of the OECD 
area takes sufficient  expansionary  action to offset the negative impact 242  Brookings Papers on Economic Activity, 1:1985 
of declining  net exports  and achieve  a 4.5 percent  growth rate in the 
period 1987-89, shows that-at  least using any sensible utility function- 
the gains from cooperation  would be very substantial. To achieve  that 
growth  rate,  countries  in the  rest  of  the  OECD  would  need  to  take 
expansionary action sufficient to produce a growth of domestic demand 
averaging 5.2  percent  in the period  1987-89,  compared  with  under 3 
percent  on present  policies.  In contrast  to the hard landing scenario, 
some part of the improvement in the U.S.  current account balance would 
be taken up by larger current account deficits in the LDCs,  since under 
these  relatively  favorable conditions  it is assumed  that they would be 
able to obtain additional financing. 
In this  cooperative  scenario,  the  monetary  authorities  are able to 
prevent the dollar from overshooting  and manage to stabilize it at a level 
consistent  with rough balance in the U.S.  current account by 1990. The 
benefits to the United States from faster growth abroad come partly in 
the form of a smaller decline in the dollar, and hence less inflation, and 
partly in the form of a more moderate  slowdown.  The benefits to the 
other OECD countries come particularly in the form of lower unemploy- 
ment;  their inflation gains  from the  lower  dollar are  somewhat  less, 
because  the dollar depreciates  less.  Significant benefits also accrue to 
the developing  countries,  which are able to grow faster and run larger 
current account deficits. 
THE  GAINS  FROM  COOPERATION 
Following is a listing of the differences  between  the cooperative  and 
hard landing scenarios,  1990 levels,  in percentages:2 
United States  Rest of OECD 
Nominal dollar exchange  rate  + 23 
GNP  +5  + 13 
Unemployment  (percentage points)  -  1.9  -  5.3 
Price level  -  2.6  + 2.4 
2.  For details,  see Dollars  and Deficits.  Note  that in these  simulations,  in which the 
dollar declines  sharply, attention is concentrated  solely  on the impact of exchange  rate 
changes on the price level,  while the latter is assumed to be invariant with respect to the 
level  of activity.  This simplification can be justified on the grounds that the slope of the 
"external"  Phillips curve linking inflation and output when  the exchange  rate changes 
appears to be more than five times steeper than the traditional "domestic"  Phillips curve. Stephen N. Marris  243 
Policy Options Facing the Other OECD Countries 
There  is at present  absolutely  no sign that Japan,  West Germany,  or 
the United Kingdom  would be prepared  to take expansionary  action of 
the required  order  of magnitude,  despite the fact that, after  two years of 
world  recovery, unemployment  in Europe  is distressingly  high  and still 
rising. 
This is indeed eloquent testimony to the strength of the belief of 
authorities  in these countries  that  they face a situation  where  expansion- 
ary demand  management  policies either  do not work or would do more 
harm  than good. The basis for this belief lies both in the experience of 
the 1970s  and in the resultant  major  changes in conventional  economic 
wisdom.3  Oversimplifying,  the arguments  are as follows. First, these 
economies have become so inflation prone that any acceleration in 
aggregate  monetary  demand  would soon lead to an equivalent  accelera- 
tion in inflation,  leaving  only a small  temporary  boost to real  output  and 
employment.  Second, because of the strength  of inflationary  expecta- 
tions-and  because of the overhang  of accumulated  public  debt-larger 
budget  deficits  would push up interest  rates  by so much  as to nullify  the 
positive impact on money incomes and demand from larger budget 
deficits.  Third,  faster  rates  of monetary  expansion  could  raise  inflationary 
expectations and lead to higher rather  than lower interest rates-this 
risk being heightened  at present because, with high U.S. interest rates 
and a strong dollar, monetary expansion could lead directly to more 
inflation  by depressing  the country's  currency  still further. 
Whatever  the strength  of these arguments  as applied  to the past, and 
to each country  in isolation, they will, to an important  extent, cease to 
be valid once the dollar  begins its inevitable  decline. For so long as the 
dollar  remains  strong,  the highly  unbalanced  U.S. fiscal-monetary  policy 
mix provides an external demand stimulus to other OECD countries, 
but at the same  time holds up both interest  rates  and-through currency 
depreciation-inflation. Once a sharp  shift out of the dollar  begins, the 
sign  on all three  of these terms  will be reversed;  there  will be downward 
pressure  on interest rates in the rest of the OECD area, and currency 
3.  Stephen Marris, Managing  the World Economy:  Will We Ever Learn?,  Essays  in 
International Finance 155 (Princeton University,  1984). 244  Brookings Papers  on Economic Activity, 1.:1985 
appreciation  will reduce inflation;  but by the same token, there will, 
after  a lag, also be a negative  external  impact  on demand.  In  other  words, 
a quite new situation  will develop that will both increase the need for 
more expansionary-or  less restrictive-fiscal  and monetary policies 
and  make  it more  likely  that  such  policies will increase  domestic  demand 
and  employment  rather  than  inflation  and  interest  rates. 
Thus, paradoxically,  Reaganomics  has, by now, created  the potential 
for a "Reagan  miracle"  in Europe  and  Japan  of the kind  enjoyed  by the 
United  States  in  the period  1983-84.  These nations  could  give themselves 
a fairly  large  dose of fiscal  expansion  and  set off a strong  rise in domestic 
demand, while inflation  would be held down because their currencies 
would be appreciating,  and budget  deficits  would not crowd out invest- 
ment because their savings would (ex ante) be flowing back from the 
United States. 
In practice  it seems unlikely  that  either  the United States or its major 
allies will make the necessary policy changes in time to prevent a hard 
landing.  This need not necessarily  be a pessimistic conclusion. History 
shows that  genuine  reform-or simply  change-in  the untidy  and  amor- 
phous entity that constitutes "the international  monetary  system" has 
generally  taken  place  only as the result  of a crisis, and  has  then  sometimes 
happened surprisingly  quickly. The last chapter of my book contains 
some suggestions as to how constructive use might be made of the 
oncoming crisis. 

The Decline and Fall of the Dollar: Some Policy Issues

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The Decline and Fall of the Dollar: Some Policy Issues

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