Monday, March 10, 2008 - The Progress & Freedom Foundation Blog

The Weak Dollar Delusion

The weak dollar is roiling not only the U.S. economy but world markets as well, as this good page-one summary in The Wall Street Journal makes clear.

What's also interesting is that finally -- finally -- even straight news articles are making the connection that I wrote about in August 2006. Namely, that monetary policy and the weak dollar are the key drivers of high commodity prices, including oil. At the time, only a few like-minded economist friends shared the view. But slowly it has become common wisdom. Here's the Journal:

The weak dollar has played a role in the latest surge in commodity prices. Yesterday, it held relatively steady, though it was languishing near an all-time low it hit last week against the euro. This year, it has weakened 4.9% against the European common currency and 8.7% against the Japanese yen.

When the dollar weakens, commodities priced in dollars effectively become cheaper for buyers holding other currencies, spurring demand. At the same time, the producers of these commodities have an incentive to boost prices, since they are getting paid in less-valuable dollars.

But high oil prices aren't the only destructive byproduct of an over-easy monetary policy. As I forewarned 20 months ago:

It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.

And since, financial disruptions are what we got.

This changing value of the crucial global unit of account -- the dollar -- is the primary cause not only of run-away inflation in dollar-linked nations, from South America to the Middle East to China, but also, of course, the subprime mess and the continuing credit crisis on Wall Street, where bonds and other securities aren't trading because parties disagree so violently about prices. Moreover, the constantly declining dollar is discouraging foreign investment in the U.S.

Many have said this is a liquidity crisis. Well, it is true certain asset classes aren't trading in normal volumes. So there is a lack of "liquidity" in some narrow markets. There is a dearth of credit between some banks and hedge funds. This is no trivial matter. But there is no broad lack of liquidity in the sense of overall money supply. Short real interest rates are negative. The Fed is hugely accommodative. Commercial and industrial loans are still flowing after recently hitting all-time highs. Most normal mortgage and consumer loans are being made, at very reasonable rates.

How can the Fed and Treasury ignore -- or even delight in -- the weak dollar amidst a slow Wall Street collapse? Because, as Steve Forbes explains in this pithy tutorial on the whole mess,

The Treasury Department bureaucracy has long believed in a weak dollar as a means of redressing the supposed problems of our trade imbalance. These bureaucrat-economists ignore copious evidence on the destructiveness of currency devaluation. Debasing your money may increase exports and reduce imports, but only for a time. Eventually costs rise, thereby reducing corporate profits. Prices are readjusted.

Although U.S. exports are up recently, we've had to import even larger amounts of expensive oil and other rising-price goods because of the weak dollar. So if the Fed and Treasury were hoping to alleviate the trade deficit, they've done just the opposite. They've exacerbated it. Now, as both domestic growth and foreign investment slow, we are indeed seeing a reduction in the meaningless trade deficit. Congratulations! Invite a recession and a Wall Street meltdown in order to "correct" a superficial, misleading, inconsequential accounting entry. Sounds like a good trade-off, don't you think?

The floating exchange rate regime and the monetary fine-tuning models, impulses, and actions of the Federal Reserve are proving, once again, to be huge failures.

The best way to begin a halt of the chaos on Wall Street and restore investment and growth would be for the Fed, Treasury, or President to say: We want a strong and stable dollar. No winks, no nods. We mean it this time, dammit.

UPDATE: See this, yet another in a long series of superb articles on the dollar by David Malpass of Bear Stearns. Malpass and I are obviously on the same page. Or, more accurately, I'm on his page.

posted by Bret Swanson @ 10:18 PM | Monetary Policy