WASHINGTON — Over the last several weeks, the dollar's depreciation against the euro and yen has grabbed global attention. In a normal world, the dollar's weakening would be welcome, as it would help the United States come to grips with its unsustainable trade deficit. But, in a world where China links its currency to the dollar at an undervalued parity, the dollar's depreciation risks major global economic damage that will further complicate recovery from the current worldwide recession.
A realignment of the dollar is long overdue. Its overvaluation began with the Mexican peso crisis of 1994, and was officially enshrined by the "strong dollar" policy adopted after the East Asian financial crisis of 1997. That policy produced short-term consumption gains for America, which explains why it was popular with American politicians, but it has inflicted major long-term damage on the U.S. economy and contributed to the current crisis.
The overvalued dollar caused the U.S. economy to hemorrhage spending on imports, jobs via offshoring, and investment to countries with undervalued currencies. In today's era of globalization, marked by flexible and mobile production networks, exchange rates affect more than exports and imports. They also affect the location of production and investment.