Economic Cocaine: America's Exchange Rate Addiction

W. L. Givens

From Foreign Affairs, July/August 1995

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Summary:  The United States is addicted to dollar devaluation. As a result, America has a false, euphoric sense of progress in its competition with Japan for key markets.

The fashionable view among economic pundits and the financial press is that American industry, led by the auto and semiconductor makers, has regained its international competitiveness in recent years. On the contrary, the root cause of virtually all of America's economic problems, from the current run on the dollar to the budget and trade deficits, is the continuing deterioration of the industrial competitiveness of the United States, most notably compared with Japan. The United States has grown dependent on the narcotic effect of dollar devaluation and the dreamy, euphoric (but false) sense of economic well?being derived from it. A massive deterioration of the dollar's value, particularly relative to the yen, has masked the problem of declining competitiveness and functioned as a habitual surrogate for both industrial policy and productivity improvement. It has become as corrosive and addictive as cocaine.

Once this dependency is established, it is likely to persist indefinitely. The trade deficit of the less competitive U.S. economy will grow while its currency dives. Nowhere is this more dramatically demonstrated than in the Japan?U.S. relationship. The dollar has been in a more or less steady decline against the Japanese yen for a quarter century while the trade deficit has continued to expand. In 1970, the exchange rate was $1 to ¥360, and the U.S. trade deficit with Japan was $1.2 billion; by March 1995, the exchange rate had reached $1 to ¥90, and the deficit was $66 billion. Furthermore, despite the perennial spate of rosy predictions, it is quite likely that the dollar will continue to fall and the trade deficit will continue to rise for the indefinite future.

THE PRODUCTIVITY GAP

Compelling evidence of that likelihood can be found, ironically enough, in the declining profitability of the major Japanese industries over the 25 years since 1970. Three industries comprise the preponderance of Japan's bilateral trade (and trade surplus) with the United States: machinery, autos, and electronics. In those industries, average operating profit levels declined from 10?12 percent in 1970 to 1?2 percent in 1994. At first glance, this would suggest that the protracted devaluation of the dollar has pushed Japanese industry to the wall, and that further yen appreciation would put them out of business.

Unfortunately, it is not so simple. The major Japanese industries have demonstrated the ability to drive their costs downward at an average compound rate of 5 percent per year for the past 25 years, while their U.S. counterparts, addicted to currency devaluation, have not. This means that the major Japanese export industries have been able to reduce their yen operating costs by virtually the same degree that the dollar declined against the yen. That their costs declined at a slightly lower rate than the dollar against the yen explains the decline in Japanese operating profits.

A similar analysis of U.S. counterpart industries shows no comparable cost reductions. American operating profits declined slightly in diversified machinery and electronic instruments, which means that costs in current dollars actually rose;ffi in machine tools, the ...

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