Does Enronitis threaten the dollar and the economy? American and French views: is the glass half-empty or half full?

Business Economics, Oct, 2002 by Paul Horne, Albert Merlin

An American and a French economist debate whether the dollar is vulnerable because "Enronitis," the bear equity market, and the weak economy may make foreign financing of the U.S. external deficit problematic. The dollar appears vulnerable because foreign financing of the U.S. external deficit is being slowed by corporate mal-governance nicknamed "Enronitis," the bear equity market, and economic weakness. Foreign investors may fear that once-respected U.S. corporate management, accountancy, legal counsel, profit quality, and regulatory institutions may be less trustworthy and that U.S. economic growth and fiscal policies are relatively less attractive. If the level of foreign investment slows below that of the current account deficit for a significant time, not only would the dollar weaken but U.S. consumption, investment, and savings patterns might have to change. Paul Horne (the American economist) argues these negative factors make the dollar more vulnerable than at any time since 1985. Albert Merlin (the French economist) responds that despite the bear market, Enronitis, and the weak economy, the U.S. lead over Europe and Japan remains so great that the dollar is not fundamentally at risk.

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Paul Horne: A Pessimistic American View

Foreign investor confidence in U.S. assets has been sharply diminished by the equity bear market, economic weakness, and--above all--the contagion of corporate mal-governance that I nickname "Enronitis." If this confidence crisis causes a prolonged slowing of the rate of voluntary foreign capital inflows, financing our unprecedented current account deficit will become problematical and the dollar could weaken enough to lead to changes in U.S. consumption, investment, and savings patterns. Available data suggest that foreign financing began to slow in 2000 with the start of the equity market correction and has decelerated sharply as corporate governance scandals and doubts about economic growth and corporate earnings exacerbated the correction into a bear market. I conclude that the dollar is potentially more vulnerable than any time since its previous peak in the mid-1980s.

The potential for dollar (USD) depreciation to overshoot is substantial if Enronitis proves to be wider spread than expected, if policy response to Enronitis and other problems appears inadequate, and if economic growth remains sub-par. Under these circumstances, international investors might further reduce acquisition of dollar assets until they are persuaded that the U.S. situation is correcting satisfactorily. Until that time, a diminished capital inflow that fails to fully finance the external deficit will exacerbate dollar weakness and increase pressure for U.S. economic adjustment.

On the other side of the Atlantic, appreciation of European currencies could increase pressure for much-needed structural and economic adjustments that might make investing in Europe more attractive relative to the U.S. Exporting companies, as well as domestic producers competing with American imports, would be forced to improve their productivity and competitiveness. A strong euro (EUR) would initially weaken European economic and employment growth, pressuring governments to implement much needed reforms of labor and product markets. Non-European investors would also benefit from increased investment in the euro area, particularly at today's sharply discounted asset prices. Ironically, USD weakness might prod Europe into action to attempt to reduce the undeniably large gap in today's relative attractiveness of U.S. and European investments that my French colleague, Albert Merlin, discusses below.

The Capital Inflow

The dollar's decline from its cyclical peak in February appears to be related to foreign investors' growing concerns about the equity market correction, weaker-than-expected economic growth, and especially--I maintain--the tsunami of corporate scandals. By September 2002, the USD was down thirteen percent against the euro since the cyclical high in February; thirteen percent versus the yen, and eight percent in trade-weighted (TW) terms against major currencies. (1) Is this depreciation short-term? Or could it be the start of a more fundamental downturn for the currency whose forty percent rise against major currencies from its April 1995 cyclical low made it a symbol of the "New Economy?"

The answer depends on the investment preferences of foreigners whose voluntary acquisition of dollar assets has financed the U.S. current account (C/A) deficit. Since 1982, our borrowing requirement increased steadily to an average annual 4.2 percent of GDP in 1999-2001 and a forecast $450 billion, or 4.3 percent of GDP this year. (2) Up to early this year, the remarkable growth of capital inflows was motivated by foreign confidence in the competitive and low-risk rate of return (ROR) on dollar assets relative to Europe, Japan, and elsewhere.

Capital inflows accelerated after 1995 when U.S. economic, capital spending, and productivity growth soared during the "new economic paradigm." Confidence was such that the capital inflow regularly over-financed the C/A deficit, causing significant USD appreciation. Net foreign direct investment (FDI) surged from a $57.8 billion in 1995 to a $307.7 billion peak in 2000. Economic slowdown, the equity bear market, Enronitis, and terrorism contributed to slow net FDI to a $130 billion annual rate in 2001 and 1Q2002. An even larger foreign flow went into "securities other than U.S. Treasury debt," a shorter-term and riskier asset class that soared from a net $156 billion in 1995 to $455 billion in 2001. (3)