The euro costs 35 percent more dollars than it did just over a year ago.  Travel discounts and previously purchased tour packages will prevent travel costs from rising that much to American tourists this summer.  But the price trend for European goods and services definitely is upward. 

In fact, the dollar has been falling in value against most world currencies in the past year.  The yen and the Canadian dollar are 6-12 percent more expensive than a year ago.  Some Asian countries also have seen their currencies rise significantly against the dollar.  The only major exceptions are in Latin America (Brazil and Argentina have seen dramatic reductions in their real and peso respectively) and in China, where the yuan buys the same dollars as it did a year or even two years ago. 

Why is this dollar weakness happening and what does the weakness mean for our economy?

The simple, and wrong, explanation for the dollar's weakness is that the U.S. is running a very large trade deficit.  The trade deficit is large, approaching 5 percent of GDP.  But the deficit was almost as large last year, and the dollar was strengthening. 

The second explanation would be that assets are earning more abroad than they are in the United States.  Therefore, investors are selling dollar based assets and buying the assets of other countries.  (To do so, investors must first convert their dollar receipts into other currencies, thus increasing the quantities demanded of those currencies. 

There certainly is some substance to this latter explanation, but it begs the question of why the change has occurred recently.  Are investment opportunities improving elsewhere or deteriorating in the U.S?

In fact, most forecasters believe that economic growth has a better chance of improving this year in the U.S. than in most other countries.  SARS is slowing the Asian economies while monetary restraint is limiting economic growth in Europe.    Indeed, the rising value of the euro will slow the growth of European exports.  Without domestic growth, some of euroland could fall into recession this year.  That certainly is not a favorable condition for investors. 

However, interest rates are higher in Europe while inflation is not.  If investors can be sure that the euro will not fall in value, they will exploit that higher rate.  A year ago, uncertainties were so strong that investors wanted to be in assets that could easily be sold.  This meant they wanted dollar based assets. 

Now uncertainties are beginning to subside.  Furthermore, interest rates have fallen so low that some money managers are having difficulty paying for administrative costs from the returns on short term instruments.  Therefore, they are searching for higher yields. 

Some of this drift to international debt instruments already was developing last year.  Once investors  became certain that the euro would not slip back below the buck, they began to buy European debt instruments.  Higher interest rates and a rising currency became an unbeatable combination that led to further euro buying. 

I mentioned a few months ago that European investors were selling U.S. equities.  This added to the euro's strength and began to create weakness for the dollar against other currencies as well.  In terms of the euro, Japan's yen has fallen significantly.  But in comparison to the dollar, the yen has become very strong. 

Frankly, the dollar weakness will continue until one of the following occurs: a) American producers become so competitive that trade deficits begin to fall sharply; b) the dollar becomes so cheap that investors no longer believe it can fall any further (this may be combined with a); or the interest rate differential vanishes after adjustment for inflation. 

Unfortunately, that last point is the most difficult to achieve.  As the dollar falls in value, prices of imported goods begin to rise.  This raises costs of production and adds to inflation (a factor that is minimal at present).

At prevailing interest rates, rising inflation would only add to the interest rate differential.  Thus, currency markets tend to over shoot the stable point, unless central banks intervene to stem the dollar's weakness through higher interest rates in the U.S. while the European central bank is stemming the euro's strength by lowering interest rates there. 

Of course, our central bank has just signaled that it will consider a reduction in interest rates at its next meeting.  No wonder international investors became more aggressive in selling dollars.  Now, will the European Central Bank realize that inflation will dissipate in Europe as the euro becomes stronger.  Therefore, they can easily lower interest rates there to discourage further inflows of capital.

I am not waiting for interest rates to fall in Europe.  Therefore, the dollar will become very weak, and American producers will begin to sell into Europe.  The trade deficit will slowly narrow and economic activity will rebound here. 

Not all of the above is bad.  But more co-ordinated activity by world central banks would make the currency adjustment much less dramatic.