Productivity slowdown at heart of weak dollar

By David McMahon - Analysis

NEW YORK (Reuters) - A slowdown in U.S. productivity growth poses a long-term challenge to the U.S. dollar and is adding to the difficulty of financing a gaping trade deficit.

The dollar has fallen to a record low against the euro this year, weakening against most other currencies along the way, as U.S. economic growth slows and economies in Asia and the Europe motor ahead.

Signalling that the dollar's woes may be far from over, U.S. productivity growth, the bedrock of a strong U.S. economy and dollar in the 1990s, has slowed for three straight years and is showing some signs of a permanent downshift.

A slowdown in the U.S. economy's cruise speed over the longer term could reduce the attractiveness of U.S. assets to foreign investors and make it harder to finance a bulging trade deficit, which last year rose to a record $765 billion.

"As productivity growth declines, the most important incentive to invest in dollar-denominated assets is no longer in place," says Hans Redeker, currency strategist for BNP Paribas in London. "I'm afraid the dollar's malaise is far from over."

The U.S. economy grew at an annual rate of just 1.3 percent in the first quarter of 2007, the slowest of all 43 countries tracked by The Economist magazine.

The Organization for Economic Cooperation and Development last week lifted its forecast for global growth in 2007, but said the economies of Europe and Japan were on track to outpace the U.S. for the first time in 16 years.

There are some signs that this is not a temporary phenomenon. Most notably productivity, which determines the speed limit of an economy's growth over the longer term, is showing signs of slowing in the United States just as it may be poised to edge higher in Europe and Japan.

PRODUCTIVITY SLOWDOWN

U.S. labor productivity growth slowed for a third straight year in 2006, and at 1.4 percent, was the lowest in a decade, the Conference Board estimates.

Some of this slowdown is to be expected, since productivity growth tends to moderate in late stages of economic growth cycles. Companies are cutting back production in response to slowing demand but keep most of their staff on the books.

Still, there are good reasons why this may be a more lasting trend. Economists generally agree that an acceleration of U.S. productivity growth in the 1990s was driven by a relatively quick adoption of new information technologies such as the Internet..

The International Monetary Fund noted in its latest survey of the global economy, however, that the benefits of the technology revolution for the United States may have largely run their course, while Europe and Japan, which lagged the United States in adopting these technologies, are catching up.

That bodes ill for the dollar, which has historically tracked growth in productivity over the longer term.

"There's a cyclical switchover and I think there's some evidence of a longer-term secular switchover in growth too, which would essentially mean we're in for a period of sustained dollar weakness," said Menzie Chinn, an economics professor at University of Wisconsin who specializes in exchange rates.