GUATEMALA CITY — There is a great deal of misunderstanding about why the dollar is in a slump. But it’s no mystery. Recently, German Chancellor Gerhard Schroeder was quoted as blaming America’s infamous twin deficits for the fall of the dollar. And many financial talking heads murmured with relief when U.S. President George W. Bush stated that his administration was committed to a “strong dollar” policy.
As it turns out, financial markets are unlikely to move in any fundamental direction or change fundamental values on the basis of statements made by one politician or another. Nor is it of much consequence to the value of the dollar if America’s budget deficit or its trade deficit narrows in the near future.
It is understandable that politicos and media-sponsored financial analysts can be so wrong. Much of the blame for the confusion in the discussion of the dollar’s condition is the fault of mainstream economists.
The simple truth is that the dollar’s retreat is due to many years of an irresponsible monetary policy and ridiculously low interest rates that flooded the world with dollars. Over 30 months of monetary easing that began in January 2001, a succession of 13 cuts pushed the federal funds rate to one-sixth its level at the beginning of the period — a record low.
With the die so cast, there is nothing in the short or medium term that can change this inalterable fact. As it is, the dollar has been in a downward trend against most of its rivals since 2001. For example, the appreciation of the euro reflects the weakness of the dollar rather than optimism about the European economies. Much the same can be said about the Japanese yen.
The best explanation for the size of federal deficits is promiscuous monetary policy that kept interest rates so low that most Americans were deterred from saving. In turn, the U.S. government turned to foreigners for much of its borrowings that repatriated the flood of fresh dollars spent by Americans to consume imports from abroad. At the same time, these same low rates have encouraged consumers to become dangerously dependent upon borrowing and debt, adding fuel to the property and other asset bubbles.
So it is a simple matter that America’s trade deficits are the result of an inflated money supply that created an artificial boom in consumer spending on the back of cheap credit. All other events involve misinformed judgments that confuse symptom with cause.
By keeping interest rates so low for so long, the Fed provided sufficient liquidity to support absurd levels of consumption while the U.S. government ran its large and growing budget deficits. Without this accommodative monetary easing, neither the trade deficit nor the budget deficit could have reached their record levels.
America’s trading partners that run neo-mercantilist currency policies so that their large capital account surpluses are converted into U.S. securities are co-conspirators in a scam. It turns out that those foreigners that choose to hold dollar-denominated financial assets are paying dearly.
In sum, the weakening international valuations of the dollar reflect the fact that America’s central bankers pumped much more money and credit into the system than its trading partners. The dollar will continue to weaken until the rate of increase of new money into the U.S. economy no longer exceeds its rate of domestic economic growth.
Along with the domestic issues thwarting upside movement for the dollar are various external conditions. Many of America’s trading partners are unwilling to reform their economies to install growth-oriented policies. Despite their efforts to reflate their own currencies, most central banks in the rest of the world have not kept pace with monetary expansion in the United States.
The lesson in all this is that sorting out the valuation of the dollar is not about intervening in currency markets. Attempts at manipulating currencies for economic advantage are a game played by either economic illiterates or political opportunists. Unfortunately, the free market process is usually blamed for harm done by exchange-rate adjustments rather than by the ill-advised architects of exchange-rate policies. The damaging effects of currency manipulation on an economy are worsened the longer a policy is in effect.
The good news is that the Fed is turning away from its policy of higher money-supply growth, although gold and commodities prices will likely rise for some time as financial assets did in the previous cycle.
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